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Cost Segregation Real Estate Opportunities

June 17, 2020

Updated August 10, 2022

Everyone wants to maximize tax savings on their commercial real estate, and while cost segregation studies have long been a solid IRS-approved strategy, these days they are more popular than ever, especially with some of the changes under the CARES Act. Here we discuss why “cost seg” studies are all the rage and look at the top-three prime cost segregation scenarios.

What is Cost Segregation in Real Estate?

Simply put, cost segregation is an engineering-based analysis in which specific property components are identified and reallocated into modified cost recovery system (MACRS) class lives. Treating the components as personal property or land improvements allows their depreciation to be accelerated. Personal property depreciates over five or seven years and land improvements depreciate over 15 years -- significantly quicker than the conventional 39 or 27.5-year depreciation periods associated with commercial or residential property. This accelerated depreciation can create up to $200K in federal tax benefits for every $1M spent on buildings or tenant improvements (TI).

Real Estate Cost Segregation Study

In addition to accelerated depreciation, cost segregation studies also provide the data required to support other useful tax strategies:

  • Tangible Property Regulations (TPR) Analysis – The TPRs provide a framework for determining whether an improvement to a taxpayer’s tangible property is capitalized or expensed. These regulations can be used combined with cost segregation data to support the immediate expensing of non-capital improvements.
  • Section 179 Expensing – This election permits the expensing of certain new or used building improvements -- roofs, HVAC, fire protection and alarm systems, and security systems – up to an amount of $1M.
  • EPAct 179D – This one-time deduction benefit incentives energy-efficient improvements, with maximum deductions of up to $1.80 per square foot of improved building space.

One study – multiple streams of savings. Sounds good, right?

It gets even better – the TCJA has boosted so-called “bonus depreciation” on five, seven or 15-year assets to a whopping 100% through 2022 (bonus rates then decline year by year until the end of 2026).

In another huge game changer, the TCJA broadened the provision to apply to acquired properties. And the recent CARES Act corrected an issue in the new tax law, assigning qualified improvement property placed-in-service after 1/1/2018 a 15-year class life, and making it eligible for that 100% bonus depreciation. In short, the cost segregation study allows real estate owners to not only accelerate depreciable assets, but dramatically increase the speed of these deductions through bonus depreciation.

Note: the CARES Act brought back net operating loss (NOL) carrybacks that allow taxpayers to carry losses from the 2018-2020 tax years back five years to claim refunds of taxes previously paid. Bonus depreciation on qualified improvement property could generate NOLs allowing taxpayers to request an immediate refund of taxes paid in prior years. These refunds could be much needed relief for taxpayers during these uncertain times.

Cost Segregation Real Estate Example

Well, this is all very intriguing, you might think, but when would I do this? Are there any events that should automatically trigger consideration of a cost segregation study?

Cost segregation studies can be helpful throughout the real estate life cycle, but are especially useful in these scenarios:

New Construction

Cost segregation takes advantage of the time value of money by front-loading depreciation to the early years of ownership. As such, to maximize savings from Year 1, a cost segregation study should ideally be performed as soon as a newly constructed property is placed in service.

Let’s look at a big example of a newly constructed hotel. Cost segregation studies can be useful for projects of all sizes, but sometimes it’s nice to look at the big numbers and get a real sense of the power of these strategies. This new hotel is nearly 400,000 square feet with 400 guest rooms, half of which are larger suites for extended stay, and half of which are fit out in a very trendy, boutique style. Multiple restaurants and banquet halls are within the facility, and the property’s depreciable basis was $92,698,000. Also, in a very impressive feature, when you turn on the television, it greets you by name.

Capstan was retained to perform a cost segregation study immediately after construction was completed in December of 2018, and engineers moved 27.4% of assets into five-year personal property. The owners were exceedingly pleased with the first-year tax savings of $8,647,253.

Acquisition

Bringing acquired property under the “bonus umbrella” has been a huge boon to taxpayers. Acquiring a property should now automatically make a buyer think “cost seg.” Consider the following example:

An owner acquired a retail facility with a triple net lease in January of 2019. The property’s depreciable basis was $4.5M, and following the good advice of his CPA, the owner elected to have a cost segregation study performed at the time of acquisition. Engineers moved 15% of assets to seven-year property and another 8% to 15-year land improvements.

This project took place in the era of tax reform, but it’s instructive to compare the actual results with the results that would have been achieved had this project been completed even one year earlier. The impact of 100% bonus on acquisitions takes first-year tax savings to a new level.

   Pre-TCJA (Bonus)  Post-TJCA (100%) Bonus
 First-Year Tax Savings  $41,027  $302,099
 10-Year NPV  $185,148  $243,693

Renovation/Look-Back Study

Earlier we said that to maximize savings, a cost segregation study should ideally be performed when a property is newly acquired or, with new construction, when the property is placed in service. However, if that ship has sailed, there’s a great alternative option. A “look-back” study allows for retroactive treatment of all the depreciation you would have gotten had you performed the study in the first year of ownership brought up to this year. The look-back study can have a dramatic increase in year depreciation deductions.

These studies are often prompted by renovations. After renovation, the IRS allows taxpayers to immediately write off the remaining depreciable basis of disposed assets. This process is called partial asset disposition(PAD) and a cost segregation study is often used to document and support this process. Data generated in the cost segregation study can create a disposition table documenting all assets removed and supporting the associated immediate write offs. This will make way for the new assets added to the depreciation schedule

Partial Asset Disposition Example

A local auto dealership was acquired in 2008, and by 2017 the owners were ready to refresh their image. They stripped the building down to its shell and replaced everything – all original siding and signage, doors, windows, roofing, plumbing, flooring, HVAC, electric and more.

The dealership’s depreciable basis was $7,945,574, and engineers moved 10.3% of assets into five-year personal property, and 31.3% of assets into 15-year land improvements. This accelerated depreciation resulted in first-year tax savings of $590,000.

However, the power of PAD took this dealership’s savings to the next level. Engineers documented the disposal of $3M of 39-year assets and $2M of 15-year assets. They determined that the remaining depreciable basis of those assets were $2.3M and $800K, respectively, for a total remaining depreciable basis of $3.1M. Assuming a 40% state tax rate, that translates to an additional first-year tax savings of $1.24M. When the significant PAD results were included, the total first-year tax savings on this dealership exceeded $2M.

Final Thoughts

Cost segregation has long been recognized as a useful strategy. However, our current uncertain situation makes it even more significant. As progress on future projects has slowed, many taxpayers are looking for strategies to get more value out of past projects. When strategically employed, cost segregation can be the vehicle by which those savings are achieved and critical cash flow is restored. Now is an ideal time to discuss cost segregation opportunities with your CPA, as it is more crucial than ever to leverage all possible tax strategies.

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