For many years, corporate accounting professionals have been taking advantage of cost segregation studies to provide significant tax benefits for their businesses by accelerating the depreciation on qualified fixed assets.
By depreciating the personal property costs of such assets over five or seven years (and land improvements over 15 years instead of the typical 39-year recovery period for general building property), the additional deductions can be used to offset taxable income. This accelerated depreciation, in turn, provides additional cash flow.
Now, due to the favorable tax law changes in the IRS tangible property regulations, those potential savings are more valuable than ever to your company’s financial future. These new IRS tangible repair regulations give taxpayers a second reason to engage in a cost segregation study: the future. Rather than focusing on the benefit of current or previous year tax deferral as in past studies, cost segregation studies have now become a multi-use tool now that can help ensure that taxpayers are complying with the final repair regulations.
More specifically, the new IRS rules made significant changes in the way companies deducted repairs and asset dispositions by setting more defined guidelines for what assets a business can expense and what assets can be capitalized. The determining factor of what defines a repair expense versus a capitalized improvement cost now lies in a case-by-case analysis of the scenario requiring the expenditure, rather than a review of the overall costs incurred. In most cases, the tax benefits resulting from expensing versus capitalizing are significant. The difference means a company is able to take an immediate deduction of the full remaining asset basis versus an incremental deduction spread out over many years.
According to the new regulations, any expenditure resulting in the “betterment” of the facility must be capitalized. That means any costs simply relating to keeping the property in an ordinary operating condition or restoring it to the same condition when it was placed in service can be expensed. Any time the expenditure creates a material increase in strength, capacity, productivity, efficiency, quality or output, those costs should be capitalized as a “betterment.” Some examples of repairs that may potentially qualify as an immediate expense would be roof membrane replacements, new HVAC system components and a “refresh” office remodeling where only the finishes are replaced.
The new rules also require an additional consideration of the specific asset being repaired and how significant the amount spent is in relation to the value of the building system being impacted. This system value, referred to as the unit of property, or UOP, is the reference point from which capitalization decisions are applied. Under the new UOP definition, expenditures relating to each building system must be evaluated as repairs or improvements only with respect to that particular system and not with respect to the entire building. The smaller the UOP, the more likely the repair costs will be considered an improvement, and therefore should be capitalized. Conversely, the larger the UOP, the more likely an expenditure will be considered a repair and therefore can be immediately expensed.
In the past, cost segregation studies were used solely to break out the personal property and land improvement costs from the overall building construction or acquisition costs. The unit of property was generally the entire building, including the structural components. However, in the final IRS regulations, the improvement analysis requires businesses to segregate their real property building costs into the building structure along with eight additional defined building systems:
• Heating, ventilation and air conditioning (HVAC) system;
• Electrical system;
• Plumbing system;
• Gas distribution system;
• Fire protection & alarm;
• Security system
The challenge for taxpayers seeking to take advantage of this change is clear: to benefit from these dispositions, they must develop a consistent and accepted method for placing a value on individual real property assets, which had previously been lumped into the 39-year “building” recovery period. A cost segregation study, when performed by qualified engineering professionals, can break out real property assets into various additional categories to allow companies to write-off capitalized repairs and maintenance costs in future years.
In addition to the eight additional UOP systems required by the repair regs, additional levels of real property can be broken out for future retirement identification purposes. For example, a new hotel property might request to have their carpeting, light fixtures and bathroom tile by floor. In this way, if the hotel undergoes a remodeling of certain floors and that property is disposed at a later date, the owner will benefit from defined and accepted values for each those components.
Cost segregation studies can also be used to minimize a taxpayer’s property tax assessments since property tax bills are based on the value of real property. After the breakout of non-value cost items from the real property basis during a cost segregation study, a taxpayer may be able to obtain a lower assessment by subtracting costs that are not real property costs from the reported costs of construction or acquisition. For example, contractor overtime hours, demolition of pre-existing structures, and even some change orders can increase the cost of the construction project, but do not add to the market value of the completed building. These expenditures can be exempted from the building’s tax basis in certain states if those costs are correctly identified and documented.
If your clients have constructed, acquired or remodeled their real estate assets in the past 10 years, they should consider the benefit of conducting a cost segregation study. The current bonus depreciation rules allow an immediate deduction of 50 percent of the total cost of all personal property assets in the year placed in service; however, this bonus depreciation will be phased out by 2019. In other words, there is simply no better time than right now to maximize the “bang for the buck” of a cost segregation study.