Having trouble raising rents? Is your facility’s cash flow starting to stagnate? Well, how about leveraging your largest deduction, depreciation through the use of cost segregation (cost seg)? A cost-seg study allocates depreciable property to the correct categories in an effort to maximize your allowable depreciation deduction.
Over the last 15 months, more self-storage owners have felt the pinch of the slower economy coupled with new competition. However, relief is available from one of the most unlikely sources: the IRS. If you own or purchased a self-storage facility and have been depreciating it substantially over 39 years, you may be sitting on a financial windfall. Self-storage is a perfect fit for cost segregation since as much as 30 percent of the cost can be classified to accelerated recovery periods. For instance, instead of 39 years, land improvements can be recovered in 15 years. This accelerated depreciation helps owners defer federal and state income taxes.
Cost seg is often looked upon by owners as a competitive advantage that they do not want to share and for good reason. The result of a cost-seg study on a typical 45,000-square-foot facility could double the after-tax cash flow in the current year depending when the facility was originally placed in service.
Cost segregation has been around for many years. It began with the landmark case of The Hospital Corp. of America vs. the Commissioner. This favorable decision opened the door for real estate owners to accelerate depreciation on real and personal property improvements.
It actually gets even better when you consider bonus depreciation and the ability for owners to correct the method of depreciating real and personal property through an automatic change process.
In 2002, the Job Creation and Worker Assistance Act (JCWA) was enacted in an effort to stimulate construction in the aftermath of Sept. 11, 2001. Recently, this temporary provision was re-enacted to allow a one-time deduction of up to 50 percent of the cost of qualified property with a class life of 20 years or less to stimulate business.
For example, if you spent $150,000 on land improvements, you may deduct $75,000 of the cost immediately and depreciate the remaining balance over the normal recovery period. This is a substantial tax benefit that should not be overlooked and will run out this year.
Change of Accounting Method
The IRS allows owners to modify the recovery period from an incorrect method to a correct method through an automatic procedure, thus encouraging owners to depreciate real and personal property correctly. The best thing about this change is it allows you to claim catch-up depreciation, which could have been claimed in prior years (back to 1987) had cost seg been used.
A successful cost-seg study requires:
- A detailed analysis of the hard and soft construction costs
- A review of construction drawings and specifications (if available)
- An inspection of the improvements to identify construction means, methods and use
- An understanding of specific building, mechanical and electrical systems
- A detailed knowledge of the tax code as it applies to cost segregation
- Combined with the ability to understand the tax and financial issues involved with real estate
Self-storage facilities make ideal candidates for cost-seg studies due to vast amount of site work required for construction. Site work such as paving, sidewalks, storm-water drainage, curbing, fencing, security lighting, underground utilities, etc., is specifically identified by the IRS as a separate asset category with a reduced life (15 years) compared to a building that has a recovery period of 39 years. Furthermore, there are other systems that can be depreciated over five- and seven-year periods, such as movable partitions, security, access gates, computerized locking or alarm systems.
A cost-seg study does not replace the accountant’s role in preparing your tax return. However, it does provide your accountant the correct values to calculate depreciation.
Let’s take a typical 45,000-square-foot single-story self-storage facility. The depreciable basis is the hard and soft costs associated with the building, site work and personal property. Let’s say the hard and soft costs total $48 a square foot for a depreciable basis of $2.1 million. Based upon our experience, 30 percent of the depreciable basis can be re-categorized to shorter recovery periods (15 years, seven years and five years) as compared to all of it being depreciated over 39 years. This reclassification tax affected at 45 percent and discounted at 6 percent yields the taxpayer a tax benefit of $107,000 over 15 years. The $107,000 represents investment income as a result of the deferment of taxes.
Once cost seg is understood by owners and their accountants, the question becomes, “Why would you not consider it?” If you acquired a facility after 1986, are planning to buy a facility or embarking on a building program, cost segregation and the bonus depreciation available under the temporary regulations should be part of your strategy to increase and improve cash flow and reduce ongoing expenses.
Mark de Stefanis is president of Construction Cost Recovery Inc., headquartered in White Plains, N.Y. The firm specializes in services such as cost segregation with a focus on self-storage. He can be reached at 914.694.3800.