Cost Segregation

Mark de Stefanis Comments
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In the case of Hospital Corp. of America and Subsidiaries v. Commissioner , 109 TC (1997), the tax court concluded property qualifying as tangible personal property under former investment tax credit (ITC) rules would also qualify in the same manner for the purposes of tax depreciation. This was a major victory for taxpayers. Practitioners can now look to former ITC rules when determining whether a property is depreciated as real property with a 39-year recovery period, or personal property with a five- to 15-year recovery period.If you own a self-storage facility, a recent tax court decision now provides a proven method to add money to your bottom line. You do this by using cost-segregation techniques--that is, segregating the various building costs into separate categories as defined by the IRS--to accelerate depreciation. This IRS decision also allows you to claim catch-up depreciation. This is the amount you could have claimed in prior years, all the way back to 1987, over a subsequent 4-year period. Since self-storage construction costs are heavily weighed toward site work, it is an ideal candidate for cost segregation.

Essentially, a cost-segregation analysis allows an owner to depreciate certain types of building components and improvements over a shorter depreciation recovery period than the typical 39 years generally used for self-storage facilities. For instance, most site work (paving, curbing, fencing, lighting, retaining walls, storm drainage and other utilities) can now be depreciated over 15 years. Many systems, such as closed-circuit television, controlled access gates, computerized locking or alarm, can be depreciated over five to seven years.

You're probably wondering, "Why hasn't my accountant told me about this?" First, the concept of cost-segregation is a relatively new one. Second, it requires an engineering skill set and expertise most accounting firms don't have have in-house, such as being able to read construction drawings, and knowing construction systems, cost estimating and how various types of IRS asset classifications relate to existing construction and use. A cost-segregation study does not replace the accountant's role in determining taxes or preparing tax documents and forms. It provides information to the accountant so the proper IRS forms may be prepared and the correct, allowable depreciation calculated.

Tax Savings

The tax savings for self-storage can be significant, since a much higher percentage of construction costs are site-work-related as compared to the construction costs for other types of buildings. If you look at a typical 50,000-square-foot, single-story facility, the depreciable basis will be the cost of site work improvements and the buildings; land is excluded and is not depreciable.

For the purposes of this example, let's assume the direct and indirect costs total $30 per square foot for a depreciable basis of $1.5 million. If a minimum of 30 percent of the depreciable basis is recategorized to recovery periods of shorter lives, which is commonly achieved through cost segregation, it would provide the owner a net-present-value tax benefit of $67,000 over 15 years, using a discount rate of 8 percent and a tax rate of 38 percent. To realize a $67,000 increase in net operating income, a self-storage facility that rents a 10-by-10 for $75 per month would have to raise rents 24 percent. And document processing with the IRS is not complicated. There is no amended tax-return refiling required--just a straightforward form prepared by your accountant.


Financial Benefits
Value of every $250,000 of project costs reclassified from long-lived to shorter-lived asset category:
Property-Life Categories 5-Year 7-Year 15-Year
First year's increase in depreciation $46,800 $32,500 $9,300
First year's after-tax (34%) benefit $15,900 $11,000 $3,200
NPV at 8% after-tax benefit: Years 1 to 10 $59,200 $55,600 $28,300
NPV at 8% after-tax benefit: Years 1 to 39 $47,600 $43,400 $26,900

A Successful Study

A successful cost-segregation study requires professional integration of engineering, architectural, accounting and tax skills. The IRS requires an engineering-based approach be employed to identify and reclassify construction costs into applicable segregated categories. A review of contractor and subcontractor payment requisitions to identify the items qualifying for reclassification into the shorter-lived asset categories is generally not enough to satisfy the IRS. A successful cost-segregation study requires:

  • A detailed analysis of the direct and indirect construction, improvement and renovation costs.
  • An examination of available drawings, blueprints and specifications (if available).
  • A physical inspection to observe and identify component utililization.
  • An expert's understanding of specific building, mechanical and electrical systems, as well as the processes characteristic of certain types of assets.
  • A detailed knowledge of the tax code as it applies to the cost-segregation process.
  • The analytical abilities and organizational skills to conduct the necessary economic and financial analysis.

Is Your Property a Candidate?

If you can answer "yes" to the following questions, a cost-segregation study will save you money:

1. Did you construct or acquire, renovate or improve the property after 1986, or is it currently under construction or in the planning stage?

2. Have you owned or do you expect to own the property for at least seven years?

3. Does the property have a positive EBT (earnings before taxes)? Or could additional depreciation help reduce current tax liabilities?

4. Is the value of the property at least $1 million?

Whether you acquired a facility after 1986, are planning to buy a facility or are embarking on a building program, cost segregation should be part of your self-storage strategy to increase cash flow, revenue and profitability. Once you understand cost segregation, there is no reason not to take advantage of it.

Mark de Stefanis is vice president of the tax engineering division of Inspection & Valuation International Inc., headquartered in White Plains, N.Y., and with branch offices in Dallas, Los Angeles, Miami and Washington. For more information, contact IVI at 914.694.1900; visit www.ivi-intl.com.

For More Info

To read more about cost-segregation studies and how they can save you money, visit the following websites and links:

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