Any economist or savvy investor will swear by the principle that a dollar today is worth more than a dollar tomorrow. This principle applies equally well to cash flow.
A dollar in cash flow created this year through accelerated depreciation of an asset will be worth more than the dollar in cash flow created from depreciation two decades from now. This time value of money is the underlying principle of a cost segregation study. By having an engineer segregate and reclassify commercial real estate assets, it’s possible to accelerate depreciation on certain asset classes and achieve significant increases in year-end cash flows.
One Size Fits All?
In a traditional tax scenario, the value and costs associated with the acquisition or improvement of a property can be deducted on a straight-line basis over a fixed term: 39 years for commercial property, and 27.5 years for residential or multifamily. So if a commercial property had an acquisition cost of $10 million, then $10 million ÷ 39 years (or $256,410) can be deducted each year from taxable income.
With a cost segregation study, whole classes of assets within the property can be deducted on an accelerated basis, sometimes in as few as five years. This results in a front-loading of depreciation, producing greater year-end cash flows in the first five to seven years of ownership than with 39-year, straight-line depreciation.
How much of a difference can a cost segregation study make on your tax return? A considerable difference, especially if you swear by the principle that a dollar today is worth more than a dollar tomorrow. To illustrate this, let’s look at a hypothetical property and compare the tax benefits with and without a study.
In this example from NAIOP, “a medical office building costs $5 million and has a 39-year depreciable life. The results of a cost segregation study determine that $500,000 of those costs are for property that has a five-year depreciable life (“five-year property”), $500,000 is seven-year property, and $500,000 is 15-year property. If we assume that the effective federal and state income tax rate is 41 percent and the discount rate is 8 percent, the resulting accelerated cash flows for years one through five total $348,343.”[i]
That’s a difference of $765,480 in deductions in the first year– not small potatoes! And for the next several years, the owner will continue to enjoy larger depreciation values and reduced income taxes.
Expertise is Not Optional
To take advantage of cost segregation benefits, the IRS has recognized that quality studies need to be detailed and engineering-based, and that “a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background.” This is beyond the traditional expertise that a CPA can provide.
A quality study in the eyes of the IRS involves a document review, analyzing building plans, cost data, leasing information, and other requisite materials. A qualified engineer then conducts a thorough on-site inspection, collecting additional information on mechanical, electrical, and plumbing systems as well as interior fixtures, finishes, and other building components. Once the data has been collected, the engineer analyzes and reclassifies the assets in specific categories (“building”, personal property, land, and land improvements). Annual depreciation is then recalculated with the new asset classes, and presents the collected data, results, and summaries in a detailed report to use for tax-planning purposes.
New, Old, Past, and Present
Cost segregation studies are an excellent choice for newly constructed or newly acquired properties, but the same advantages can be applied to buildings placed in service in the past (after 1987), buildings recently renovated, and even after a property is sold. In these scenarios, depreciation deductions for prior years can be recomputed and applied to your current-period deduction under a one-time catch-up provision (Sec. 481(a) adjustment), instead of having to amend prior-year returns.
The EBI Approach
An EBI Cost Segregation Study gets you the maximum depreciation allowed by current tax code, reducing your overall tax liability, and increasing year end cash flow. The overall effect is more cash in your pocket, year after year, during the first seven to fifteen years of ownership.
EBI Consulting provides best-in-class acquisition services to help clients invest wisely. Our nationwide team of experts can develop custom scopes of work to address all your due diligence needs, whether it be comprehensive property condition reports or specialized services like cost segregation studies. EBI’s Acquisition Services team delivers next-level analysis to help you make next-level business decisions.
If you’re interested in a cost segregation study or any of our other exceptional acquisition services, contact us to speak with a consultant today.