Editor's note: This column originally was published in a Sperry Van Ness/Rankin Co. e-newsletter.When it comes to commercial real estate, what property owners don't know about cost segregation can hurt them in the long run.
In third-quarter 2006, the Internal Revenue Service allowed national restaurant chain International House of Pancakes a tax savings of more than $8.5 million, mostly due to reclassified depreciation on its commercial property. This was like found money for a corporation whose traditional financial wizards overlooked a little-used tax tool known as cost segregation.
Simply put, cost segregation re-classifies different materials in a building based on each item's estimated life span.
In the past, everything in commercial buildings, including the building itself, was normally depreciated over 39 years, no exceptions and no matter how illogical that time frame. As most property owners know that features such as carpeting, asphalt, specialty electrical systems and plumbing all wear out long before 39 years or must be replaced during tenant turnover.
With cost segregation, however, each of a commercial property's components can be dealt with individually, according to preset standards, and classified as personal property by the IRS. In a 1997 tax court case, Hospital Corporation of America successfully defended the application of engineering-based cost segregation as a viable method to differentiate real and personal property under existing tax law. This landmark case continues to be the cornerstone of cost-segregation studies.
What came out in the court case was that the IRS recognized its potential liability and created what was comparable to a "don't ask, don't tell" policy. For this reason, the court had to create a starting point from which commercial property owners could claim accelerated depreciation. With this ruling, all commercial property and tenant improvements placed in service after January 1986 became eligible for the savings.
In 1999, the IRS issued a legal memorandum, which said that "reclassification of assets into shorter periods would not be contested." And in 2004, the IRS reaffirmed the methodology by issuing the Cost Segregation Audit Guide. Until recently, such studies were extremely expensive, and it was difficult to find experienced engineers from a variety of disciplines who could perform them.
Owners' bottom-line savings - as much as 25 percent of the building's value - can be recouped within the first five years of ownership. Some services are ideal for buildings valued at between $1 million and $10 million, and these savings can be applied to offices, apartments, hotels, automobile dealerships, factories, warehouses and restaurants. The potential can be enormous when property is reclassified into an accelerated depreciation schedule.
Cost segregation can be used by owners who have purchased real property or constructed new facilities since 1987; renovated or restored existing properties; installed improvements in existing buildings; and paid income taxes while they owned the properties.
Each building, however, must be viewed as a unique situation, so check with your tax advisers to see if cost segregation could be beneficial.[[In-content Ad]]
Mike Fusek is a senior adviser with Sperry Van Ness/Rankin Co. LLC in Springfield. He may be reached at mike.fusek@svn.com.
