By Jerome H. Kootman
Many self-storage owners are becoming increasingly familiar with the powerful cash-flow improvement concept of accelerated depreciation deductions resulting from cost segregation. Recent developments, including 50 percent and 100 percent first-year bonus depreciation, continue to enhance the opportunity to generate significant additional cash flow during these difficult economic times. This additional capital can be used for renovations, buying new property and strengthening the balance sheet.
This article will discuss the latest developments on the lucrative first-year bonus depreciation regulations and provide examples on how to increase cash flow through optimal year-end tax planning.
What Is Cost Segregation?
Cost segregation is a cash-flow improvement strategy that maximizes depreciation deductions for all buildings. Dramatic cash flow benefits can be achieved by reclassifying components of the building into their proper depreciation schedules of five, seven and 15 years, using accelerated depreciation methods. While this may seem to be inconsequential at first, the cash-flow effect of this reclassification is significant and immediate.
Benefits of cost segregation include:
- Accelerated depreciation expense
- Reduced corporate and/or individual income taxes
- Increased cash flow
- Quicker return on investment
This is not simply a matter of classifying equipment to a five- or seven-year recovery period. Items typically reclassified include land improvements, such as paving, curbing, storm drainage, fencing and landscaping, as well as personal property like signage, security systems, movable partitions, certain floor coverings and special climate-control systems. The list is extensive and requires a cost-estimating background and familiarity with tax regulations to maximize the benefit.
First-Year Bonus Depreciation Update
The federal government reinstated first-year bonus depreciation for eligible properties (recovery period of 20 years or less) acquired after Dec. 31, 2007. The goal of this initiative was to incentivize growth and stimulate capital expenditures. The bonus depreciation rate was originally set at 50 percent, which meant half of the cost basis could be written off in the first year, with the remaining balance recovered over the typical depreciation period of five, seven or 15 years, depending on the particular asset.
The bonus depreciation rate increased to 100 percent in September 2010 but reverted back to 50 percent as of Jan. 1. Any purchase of equipment, or in-process construction/renovation projects, needed to be in service prior to Jan. 1 to take advantage of the more favorable regulations.
The next milestone is Jan. 1, 2013, when the 50 percent rate expires altogether and bonus depreciation will no longer be permitted. While, it is possible the federal government will move to extend the expiration date as it has in the past, this warrants monitoring for future developments. Knowledge of the various first-year bonus depreciation scenarios is crucial for proper capital expenditure planning.
I recently completed several cost-segregation studies of self-storage properties (see Table 1). It is important to note that these studies generate opportunities to use first-year bonus depreciation by identifying property components with recovery periods of 20 years or less. The second property listed in the table took advantage of the 50 percent first-year bonus depreciation to generate tax savings of $208,834 in the first year. Not all properties are eligible for this lucrative incentive. Cost-segregation specialists can identify opportunities for these and other special cases.
Table 2 illustrates the annual depreciation deductions for the first facility in Table 1. The total additional depreciation of $734,721 over the first five years generated tax savings of $299,990 during the five-year period. The annual change in depreciation over the life of the property is included in the accompanying chart.
To see the image, "Self-Storage Acquisition: Additional Depreciation and Tax Savings Over the Life of the Property," click HERE.
Although the best time for a cost-segregation study is when the self-storage property is acquired or constructed, its also possible to obtain these benefits for properties that have been owned for up to 15 years. A retroactive study can be performed without amending prior-year tax returns. You can claim the difference between the allowed depreciation and what you actually claimed in prior years all on your current tax return.
The third property listed in Table 1 is an example of a retroactive study. The first-year tax savings are usually tremendousin this case, $251,851 for the 2010 tax return.
Its important to note that a cost-segregation study is typically economically feasible for properties with a depreciable cost basis greater than $1 million and should be considered by any self-storage owner who has recently acquired property, started or completed a construction project, or acquired property within the last 15 years that didnt already have a study performed.
Cost-segregation professionals make it simple to determine if a property is a candidate for a study. Based on a brief discussion with you or your accountant, they can provide a free projection of benefits and projected depreciation schedule so you can see how it will affect your tax return.
Jerome H. Kootman is managing tax director for Cost Recovery Solutions LLC, a specialized engineering and tax consulting firm that provides cost-segregation services. He has completed cost-segregation studies for hundreds of clients, ranging from small businesses to Fortune 100 companies. He can be reached at 732.548.3855; e-mail firstname.lastname@example.org .