By Mark de Stefanis
Cost segregation has long been regarded as one the best tax strategies available to self-storage owners. Its better than found money. Its your money! Whether you acquired a facility after 1986, are planning to buy a facility, or are embarking on a building or replacement program, cost segregation should be part of your strategy to maximize cash flow.
This method of accelerating the depreciation deduction has withstood the test of time and is endorsed by the IRS. But get this! Recent changes buried in the repairs and maintenance regulations are like cost segregation on steroids. The new regulations favor self-storage owners by allowing a write-off on retired structural improvements. This major change will have a positive impact on all commercial real estate and is available now and on a retroactive basis. It also helps level the playing field for facilities that compete against real estate investment trusts (REITs).
The new regulations allow self-storage owners the ability to write off the adjusted basis of retired structural components (doors, windows, roofs, fixed partitions, flatwork, etc.). This is a significant departure from past practices that required taxpayers to continue to depreciate structural improvements over the remainder of the 39 years even though the items no longer exist. On the flip side, the regulations also provide some complex guidance related to whether an item is deductible as routine repair and maintenance or must be capitalized.
Retirement of Structural Improvements
Ever since the end of the component-depreciation system, owners have complained about a requirement to continue depreciating physically abandoned assets. Those of you whove been around for a while may recall that the system conjoined the estimated useful life of an asset and its recovery period. This alleviated the concern of recording a loss on the retirement as long as the asset performed within its life expectancy. However, under the Accelerated Cost Recovery System (ACRS), the link between the estimated useful life and the recovery period was lost. This resulted in owners continuing to depreciate items that no longer exist.
The doors on a self-storage facility take a great deal of wear and tear and are the most common items that require replacement. Unfortunately, IRS guidance still requires self-storage owners to capitalize the costs of replacement doors. This was not an issue under the component-depreciation system if the doors performed according to their specification (15 years), since the doors were 100 percent depreciated when it was time for replacement.
Under the current depreciation system, the doors on a self-storage facility are depreciated over 39 years. Unfortunately, doors that are replaced at the end of their useful life are only a little over 38 percent (15 years/39 years) depreciated. In the past, the self-storage owner couldnt write off the adjusted basis on retired doors or any other structural improvement. Furthermore, the new doors also had to be depreciated over 39 years. Therefore, prior to the recent change, an owner was required to depreciate the original and replacement doors at the same time.
Fast forward to life under the new regulations. The IRS allows self-storage owners to write off the undepreciated portion of the retired doors on a current and retroactive basis back to 1986. If you have a 350-unit facility built in 1995, youre probably depreciating 350 doors that no longer exist. The accompanying chart shows the tax ramifications of a door replacement on a 350-unit self-storage facility.
The time has come to write off all of the abandoned assets that have accumulated over time. If you retire an asset in 2012 or any future years, you will be able to take the appropriate write-off in the relevant tax period. However, the timeframe for taking the writing off on legacy assets (assets retired prior to 2012) will expire on Dec. 31, 2014.
If you want to take advantage of the write-off on a retired structural component, you need to have something in the file to support your position. The IRS recommends a reasonable allocation of cost. The appropriate support is a cost-segregation study that breaks out the individual capitalized components. For those whove had a study completed in the past, call your cost-segregation provider and ask which line item in the study relates to the specific retirement. If you havent had a cost-segregation study, consider getting one, as it will save you at a minimum of 10 times the fee even before taking into consideration the benefit on a write-off.
Essentially, a cost-segregation analysis allows an owner to depreciate certain types of building components and site improvements over a shorter depreciation recovery period than the typical 39 years generally used for the structural elements of a self-storage facility. The benefit to the owner is simple. By deferring taxes through the use of accelerated depreciation, owners retain more cash. A typical self-storage facility of 45,000 square feet will see a savings between $50,000 and $75,000.
There are two reasons why a cost segregation is beneficial to a self-storage owner:
- Self-storage facilities typically have extensive site work such as paving, curbing, fencing, lighting, retaining walls, storm drainage and other utilities, etc. These items are specifically identified by the IRS as property that can be depreciated over 15 years instead of 39 years. Furthermore, there are other systems that can be depreciated over five or seven years such as movable partitions, furniture, fixtures and equipment, CCTV security, controlled access gates, computerized locking or alarm systems, etc., to name just a few.
- Due to the recent change in regulations, the detail in the cost segregation can support future write-offs of structural components that require replacement.
Some of you might be saying, Why hasnt my accountant told me about this? Well, maybe the timing wasnt right, you have enough deductions and do not pay taxes, or your accountant just doesnt think self-storage is a good candidate. Whatever the reason, its not too late if you want to save on tax payments.
Some common questions include: Will this trigger an audit? Do I have to file amended returns? Is this risky or out-on-the-edge accounting? The answer is no to all. Cost segregation is an IRS-approved and sanctioned method for which the IRS has published guidelines.
Repair vs. Maintenance
When it comes to new regulations, we often have to take the good with the bad. The good news is we now have the ability to write off the un-depreciated portion of the old/retired doors. The bad news is we have some repairs and maintenance guidelines that are more complex.
If you ask the IRS, everything must capitalized and then depreciated. If you ask a self-storage owner, everything expended is related to repairs and maintenance. It will not surprise you to hear that simplification wasnt the priority when drafting the new regulations. Regardless, the following matrix may help:
If you do need to capitalize costs, its important to recover it over the shortest period possible. This is where the cost segregation comes into play.
Now self-storage owners have another tool in their tax arsenal to help keep more of the their money. The benefit is similar to raising your monthly rental rates by 5 percent without running the risk of having any tenants move out. With all of the competition out there, the question you should ask your accountant is why dont either of these strategies work for you?
Mark de Stefanis is president of White Plains, N.Y.-based Construction Cost Recovery Inc. The national firm consists of accountants, architects, engineers and cost professionals who provide value-added services to real estate owners. Services include cost segregation, construction-cost auditing and replacement-cost analysis. For more information, call 914.740.1995; visit www.ccrtaxaudit.com.