For starters, 2005 is the last year to take advantage of the 50 percent bonus depreciation on improvements with a class life of more than 10 years, as well as the increased deduction allowed under Internal Revenue Code Section 179. In addition, you may be in a position to increase cash flow through cost segregation, which assists property owners through the deferment of taxes. Self-storage is a capital-intensive business. Understand the tax benefits at your disposal, and make the most of your business.
The bonus-depreciation provision introduced by the IRS in 2002 and expanded by the Jobs and Growth Tax Relief Reconciliation Act of 2003 is about to fade into history. For a limited time, it allows an additional first-year depreciation deduction equal to 50 percent of the basis for qualified property. While the proviso has lost some of its luster, there are still benefits available to owners who entered contracts prior to Jan. 1, 2005, and will complete construction by Dec. 31.
For example, on an improvement that would be recovered over a 15-year period, the first-year depreciation deduction would normally be 5 percent. However, by leveraging the bonus depreciation, this same asset would qualify for a total first-year deduction of 55 percent.
A provision of Internal Revenue Code Section 179 temporarily allows small-business owners to deduct personal-property improvements in full instead of capitalizing and depreciating them over the appropriate recovery period. It also increased the dollar limitation for qualifying property from $24,000 to $100,000, providing the assets are placed into service by Jan.1, 2006.
These are significant benefits, so if you’re considering projects such as upgrading your computer system, renovating your office or installing a surveillance system, act now. Expensing qualified property under Section 179 could lower your adjusted gross income and reduce your overall tax liability. But once 2006 rolls in, this benefit will revert back to a maximum of $25,000.
If you’re depreciating your storage facility over 39 years, you could be sitting on a financial windfall. While the window of opportunity tends to close rapidly on most traditional methods of tax deferment, cost segregation is different because it puts the taxpayer in control of the change.
With cost segregation, you may be able to recoup a large portion of your estimated tax payments. Why? The IRS allows taxpayers who are currently depreciating land improvements over 39 years to change their method of accounting, using Form 3115, to recover those same improvements over a 15-year period instead. The new method results in a 481 adjustment, otherwise known as catch-up depreciation. The modified amount could significantly reduce your current-year tax liability and provide the necessary cash to improve your business.
An Ideal Candidate
Self-storage is an ideal candidate for cost segregation since as much as 30 percent of its costs can be classified for shorter recovery periods. A self-storage project has a vast amount of site work (paving, storm-water drainage, curbing, fencing, security lighting, underground utilities, etc.), which has been specifically identified by the IRS as a separate asset category with a reduced life of 15 years vs. the actual building or buildings, which have a life of up to 39 years. Furthermore, there are other systems that can be depreciated over five- to seven-year periods such as CCTV, gate access, alarm, etc.
A typical 50,000-square-foot, single-story facility with direct and indirect costs of $35 per square foot has a depreciable basis of $1.75 million. If 30 percent of that can be reclassified to shorter recovery periods of five, seven or 15 years instead of 39 years, the taxpayer will experience an additional $85,000 in cash flow over a 15-year hold. The additional money could be used to finance his next phase, increase the competitive features of the property or buy a new sports car!
Achieving Cost Seg
You’re probably wondering why your accountant hasn’t told you about the benefits of cost segregation. Truth be told, it requires an engineering skill set and expertise most accounting firms don’t have in-house, such as being able to read construction drawings as well as knowing mechanical systems, cost estimating and how various types of IRS asset classifications relate to existing construction and use. What does a successful study require?
- A detailed analysis of a facility’s direct and indirect construction costs
- An examination of drawings and specifications (if available)
- An inspection of the facility to observe and identify component utilization
- An expert understanding of specific building, mechanical and electrical systems
- Detailed knowledge of the tax code as it applies to the cost-segregation process
- Analytical abilities and organizational skills to conduct the economic and financial analysis
There are several firms that specialize in cost-segregation services. Considering that a study could double a facility’s after-tax cash flow, it may be worthwhile to investigate. A cost-segregation study does not replace the need for an accountant when it comes time to prepare tax documents and forms. It simply provides him with correct figures so forms are completed in line with allowable practices.
Whether you acquired a facility after 1986, are planning to purchase an existing site or embarking on a new build, you should take advantage of the tax benefits available. This year, make the most of bonus depreciation and enhancements to Section 179. Moving forward, use cost segregation as part of your strategy to reduce ongoing expenses and improve overall cash flow.
Mark de Stefanis is the president of White Plains, N.Y.-based Construction Cost Recovery Inc., which specializes in services such as cost segregation with a focus on self-storage. For more information, call 914.694.3800.
A Landmark Case
In 1997, the case of Hospital Corp. of America and Subsidiaries v. Commissioner opened the door to accelerated depreciation techniques. The tax court concluded that 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 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.
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 four-year period. Since self-storage construction costs are heavily weighed toward site work, it is an ideal candidate for cost segregation.