The Cost Segregation Study That Should Not Have Been Done
Written by Steve Beaucaire, MST, CCSP and Greg Bryant, CCSP
Over the last week, the most recent buzz in the Cost Seg world has focused on the Peco Foods case. (Peco Foods Inc. et al., TC Memo 2012-18). Many of our clients have asked us to weigh in on this issue. By way of reference, Peco Foods acquired two poultry plants from Green Acre Farm, Inc. in 1995 for $27,150,000. Part of the acquisition included a very elaborate Purchase Price Allocation (PPA) between the parties. The PPA went as far as delineating the costs for assets such as specific process related items, land improvements, buildings and goodwill. Further, the PPA was very explicit with respect to the definitions of Real and Personal property as they pertained to the specific transaction. These definitions were more than the generic “land and building” descriptions we normally see in a PPA. The fact that this level of detail existed unilaterally negated Peco’s ability to conduct a cost segregation study (CSS). Additionally the PPA contained specific language that the allocations were to be used for all purposes including financial accounting and tax purposes.
Given TC Memo 2012-18, we are now fielding questions from our clients as to the validity of look-back studies and how this is going to impact our business. Our response is “Nothing has changed!”
This recent Tax Court case does not add anything new to the use of a CSS as a tax-planning tool. The concept of a PPA overriding a CSS has been settled for years and is found in § 1060(a). This concept is even mentioned in the Audit Techniques Guide for Cost Segregation Studies as something agents should look for when auditing a CSS. When completing Form 8594, Asset Acquisition Statement under § 1060(a), one must allocate the purchase price to general categories.
• Class I assets are cash and general deposit accounts other than certificates of deposit.
• Class II assets are actively traded personal property, for example, U.S. government
securities and publicly traded stock.
• Class III assets are generally debt instruments (including accounts receivable) with
some limitations.
• Class IV assets are inventory items, or property held by the taxpayer primarily
for sale to customers.
• Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets.
• Class VI assets are all section 197 intangibles, (patents, copyright, trademark or
trade name, or covenant not to compete), except goodwill and going concern value.
• Class VII assets are goodwill and going concern value.
The IRS, however, applies the definition of items included in the asset allocation rules very broadly. It is to the purchaser’s advantage to classify as much as possible under the rules into Class V, which is the silver lining. Class V assets can later be segregated into personal vs. real property via a cost segregation study, as these amounts do not constitute any allocations to § 1245 or § 1250 property. Peco Foods’ undoing was attaching a statement to Form 8594 allocating specific amounts of the Purchase Price to Processing Plant Buildings and Real Property Improvements, thereby casting these in stone.
We have seen punitive examples where buyers and sellers agreed to PPA resulting in unintended consequences. Sometimes “innovative strategies” designed to minimize local items such as Real Estate Transfer tax have their unintended consequences at the Federal level, just like one of our clients who elected to have 90% of their golf course purchase allocated to land. The good news was on that transaction, the buyer and seller were able execute appropriate amendments to the purchase agreement and our client was able to take advantage of cost segregation. An important note on amendments and PPAs – they are binding on both parties.
While the rational behind the Peco Foods decision is not new, it does point out that one must pay attention and know the rules before making decisions on performing a CSS. Communication between the taxpayer, their accountant, and the cost segregation provider is paramount.
Estate Planning & Cost Segregation
Contrary to popular misconception, the concepts of estate planning and cost segregation are not mutually exclusive. In fact, a cost segregation study can enhance the estate planning process by lowering the tax burden of the property owner. Rather than trying to describe this, we will use an example to explain how they work together.
In the example, we assume that a husband and wife own property jointly. They acquired this property by a purchase for $10,000,000 10 years ago and have been depreciating this property under MACRS 39-year class. At this point in time, a cost segregation study is performed for adoption in 2011 with the following results.
Example
5-year property equals 18% or $1,800,000.15-year property equals 15% or $1,500,000.
39-year property equals 67% or $6,700,000.
The basis property is $5,000,000 for the husband and $5,000,000 for the wife.
The husband dies in 2013 and a valuation is done on the property, as is required by law. The new valuation has the building at $12,000,000.
The basis of the husband is stepped up to $6,000,000 as it passes through the estate to the wife. Therefore, even though the valuation is for $12,000,000, the depreciable basis is only $11,000,000. The placed in service date remains the same for the wife’s original assets, but a new placed in service date is used for the portion that passes through the estate.
At this point, a second cost segregation study can be performed as the property has been revalued. The results are shown in the table below on the line for 2013.
Let us further assume that the wife dies in 2017. The valuation placed a new value on the property of $15,000,000. As the entire property has gone through the estate, the valuation and the depreciable basis are the same and a third cost segregation study is done.
Please note that because the property went through the estate no depreciation recapture was required even though the owners were allowed to step up the basis of the property.
The above discusses just one example of how cost segregation can be used in the estate planning process. Of course, there are other applications, such as the issues associated with partnerships and the implications of §754.
Bottom Line
The two key benefits of using cost segregation in the estate plan are the acceleration of depreciation and the ability to avoid potential recapture. Both have a significant and positive impact on cash flow.
Taking Advantage of Current Tax Incentives
As we enter the fourth quarter of our calendar year, tax planning becomes more of a focus for many business owners. The day-to-day challenges of running a business can sometimes contribute to overlooking some very favorable tax incentives that are set for expiration or reduction come year-end. The following are some items that you should consider as part of your year-end tax planning depending on your situation:
New Construction or Renovations
Certain improvements placed in service prior to December 31, 2011 are eligible for 100% bonus depreciation. For example, a typical auto dealership with new construction costs of $3 million will save, on average, over $200,000 in taxes simply by conducting a cost segregation study. Additionally, there are numerous tax deductions of up to $1.80 per square foot available for meeting certain energy efficiency thresholds.
Existing Facilities
For those who have yet to take advantage of cost segregation, not all is lost. The IRS permits the use of “look-back” studies to capture the accelerated depreciation you were entitled to take – but did not. This sometimes very large deduction is taken in a single year and is equal to the difference between what could have been depreciated vs. what you actually took. It gets even better because all this is done without having to file amended tax returns! Look-back studies can mitigate significant tax liabilities for the current tax year by creating a very large “catch up” deduction that can be used right away. Also, these types of studies can be used on a “loss carry-back” basis for two previous tax years to obtain tax refunds, to the extent you paid taxes in those years.
Considering a Lighting Upgrade?
There a few programs available to auto dealers which provide 100% financing for turn-key interior and exterior lighting upgrades. In most cases, upgrades have a payback of less than two to three years and are “cash neutral”. This means that the energy savings underwrite the monthly costs of the lighting program. In addition, there are a limited number of firms that will guarantee the operational savings and coordinate all grants and incentives available from state and local entities – as well as those from the utility companies! From a tax perspective, a large part of lighting upgrade projects will be subject to 100% bonus depreciation in 2011.
Planning a major building project in 2012?
Proper planning at the design stage can yield considerable benefits. The integration of your tax consultant with your design team will enable you to make informed decisions and maximize tax benefits. For example, an owner is making a decision on whether to use a traditional heating and air conditioning system vs. a geothermal system. At first glance, the geothermal system is more expensive; however, once the owner is made aware that the geothermal system is categorized as “Qualified Energy Property” and is subject to 100% bonus depreciation, the decision becomes a very easy one.
Bottom Line
While the temporary tax incentives are set to be reduced on December 31, 2011 and to expire on December 31, 2012 there is still plenty of time to capitalize on the benefits and keep more cash in your pockets!
Cost Segregation Applications: Design and Construction
Although there are many applications for cost segregation, new construction projects are often first to be considered. It’s always good to have a cost segregation study performed as soon as a property is placed in service. This allows the taxpayer to take full advantage of accelerated depreciation deductions from day one.
Normally, the request to perform the cost segregation study comes after construction is completed and the building is placed in service. While substantial benefits are generated by performing a study at this stage, even greater benefits can be achieved if the cost segregation provider is involved directly from the design phase. Unfortunately, many owners and tax advisors are unaware of this valuable opportunity and many cost segregation consultants are unfamiliar with, or lack the engineering and construction expertise, to utilize this application.
Design Phase
Getting your cost segregation consultant involved during the design phase can be very beneficial, especially on larger or more specialized projects. Early involvement allows the cost seg provider the opportunity to understand the project and make valuable suggestions before it’s too late. While some issue can be addressed during construction, it is better to know ahead of time to avoid unnecessary change orders. Ideally, you’ll want to make this introduction after the conceptual drawings are finished, but before the project goes out to bid. This will also provide an opportunity to request bids in a format that is more conducive to performing the study.
The recommendations made during design will mostly deal with the types of materials being used and manner of affixation. Both are important things to consider from a tax perspective. Small changes to design or types of materials can generate large tax benefits.
A classic example is whether to use paint or some form of removable wall covering. Paint is depreciated using a 39-year recovery period, while removable wall coverings can be depreciated over five or seven years. Additional design elements to consider include wall partitions, floor coverings, lighting, and canopies, among others.
The design phase also provides an opportunity to check how drawings are labeled. The intended use of an asset is a key consideration in determining whether it will qualify for a shorter recovery period. Detailed labeling can help provide a more defensible position with regard to intended use. Lighting is a great example of this. Labeling the panel schedule of the blueprints to separately identify base building and accent lighting provides a clear distinction. Base building lighting is a 39-year item in the eyes of the IRS, but accent lighting can be depreciated over five or seven years. This is especially important in properties that have a high percentage of special use assets, such as medical facilities, auto dealerships, restaurants, and manufacturing facilities, to name a few.
Construction Phase
From a cost segregation standpoint, there are two important elements of the construction phase. First is the ability to make last minute suggestions pertaining to materials and installation. Change orders may affect the initial design and will need to be reviewed. Second is the documentation process. Building a defensible position for the classification of assets is the cornerstone of a good cost segregation study. Solid photographic and/or video documentation is a key part of this process. Involvement during construction gives the cost segregation provider the ability to document aspects of the property that will not be visible once construction is complete.
The Bottom Line
Getting a cost segregation provider involved early can provide real value, but it can also create some challenges. It is important that the cost segregation provider is familiar with the entire design and construction process so they don’t get in the way. The last thing the design and construction teams want is someone slowing down their progress.
Although it’s tempting, don’t assume that the architect or contractor can properly allocate costs or prepare a defensible cost segregation study. Most architects and general contractors don’t have knowledge of the tax regulations and won’t be willing to defend the taxpayer in the event of an audit. Go ahead and spend the extra time finding a reputable cost segregation consultant who is able to identify opportunities and provide recommendations to ensure you achieve the most favorable tax treatment.
Cost Segregation Applications: The Look-Back Study
A cost segregation study performed on a property placed in service in years past, where a tax return has already been filed, is known as a look-back study. Properties already in service are often overlooked when it comes to cost segregation, however a property does not need to be newly constructed to reap the benefits of this tax planning strategy.
The IRS permits taxpayers to use a cost segregation study to adjust depreciation on properties placed in service as far back as January 1, 1987. Many property owners and tax advisors share a common misconception that once the three-year statute to amend has expired, the taxpayer can no longer make a change. Fortunately, this is not the case.
Upon completion of the study, the taxpayer is allowed to make an adjustment under IRC §481(a) to catch up on depreciation. The catch up, which is taken in a single year, is equal to the difference between what was depreciated and what could have been depreciated if a cost segregation study was performed on day one. Expectedly, these benefits can be quite substantial. As an added bonus, the change can be made without filing an amended return. The taxpayer simply files Form 3115 (Change in Accounting Method) with the cost segregation study attached.
Example
Perhaps the best way to explain the benefits of a look-back study is to provide an example. Let’s use a $10M office building that was placed in service in March 2005, where 100% of the property is being depreciated using a 39-year recovery period. We’ll assume that a study was performed for the 2010 tax year which identified $800K (8%), that could be reallocated to a 5-year recovery period.
In this scenario, the taxpayer realizes a §481(a) adjustment just over $655K. Combined with the first year depreciation, the total deduction in year one is more than $680K. Using a 35% effective tax rate, the taxpayer realizes over $238K in first year savings. Ten years out, the Net Present Value (NPV) is still almost $190K and in year 40 of the property’s life the NPV is still more than $136K. Needless to say, the financial benefits of front loading depreciation deductions via a cost segregation study are huge.
Bottom Line
A cost segregation consultant, working in conjunction with the tax advisor, will be able to help determine the appropriate strategies to take advantage of this technique. Since look-back studies often identify significant amounts of reclassified assets as well as very large §481(a) adjustments, there is a slightly higher probability that the study may be subject to IRS scrutiny. This further underscores the need to choose a highly qualified cost segregation provider, with experience performing look-back studies, which will stand behind their work in the event of an IRS challenge.
Choosing a Cost Segregation Provider
The cost segregation industry has significantly evolved over the past few years. As a result, property owners and accounting firms are seeking to work with established cost segregation specialists.
The following are important things to consider when choosing a cost segregation provider.
Experience
How long has the business been performing cost segregation studies and how many studies have been completed? This can be a complicated thing to find out and you may have to do some homework. Some new start-up firms are claiming they’ve performed 5,000 studies or more. Of course, this isn’t necessarily true. You see, most cost segregation providers have less than five engineers on staff. On average, an experienced cost segregation engineer can perform 50 studies per year. Therefore, a firm with five engineers would have to be in business for approximately 20 years to complete 5,000 studies.
Performance
Who will be performing the work? Does the firm employ any degreed engineers or professional engineers (P.E.s)? Since the IRS stressed the importance of an engineering-based study in the ATG, many firms have jumped on the engineering bandwagon. Unfortunately, this has become a kind of buzz word that firms use to market themselves.
What methodology does the firm use? Verify that they use a detailed engineering approach and provide a breakdown of all costs, including those that do not qualify for accelerated depreciation. If they don’t, you or your client could be facing additional risk in the event of an audit.
Find out if the firm subcontracts its cost segregation work to a third party. If so, be sure to find out their credentials as well.
Audit Defense
How will the firm defend its work in the event of an audit? Find out if there is an additional expense for audit support, what the limits are, if the firm retains the necessary records, and what experience they have defending their studies before the IRS.
References
Last but not least, always ask for references!
Bottom Line
The bottom line is that you should seek advice from a qualified professional with considerable cost segregation experience. Make sure you are working with a firm that employs real engineers as well as the appropriate tax experts.
You may end paying a bit more for the expertise, but it will be well worth it – especially if you are ever called into an audit.
What is cost segregation?
Brief Overview
A cost segregation study (CSS) allows a taxpayer to accelerate substantial depreciation deductions by identifying costs that can be allocated to shorter recovery periods; primarily 5, 7, and/or 15- year as opposed to 27.5 (residential rental) or 39-year (commercial).
By reallocating these costs to shorter recovery periods, taxpayers can defer substantial tax payments and greatly improve cash flow. Be aware, however, that a cost segregation study does not create new tax deductions, it simply pushes deductions into the early years of ownership. This front-loading of depreciation allows the taxpayer to take advantage of the time value of money. And, as we all know, any amount of money is worth more the sooner it is received.
While property owners and their tax advisors routinely utilize cost segregation following the purchase or completion of a building, there are many additional applications of the practice that apply to the various stages of real estate ownership and development.
Project Fees
The fees associated with a cost segregation study have gone down considerably in recent years, making it possible for smaller property owners to utilize engineering-based cost segregation. The decline in project fees is primarily due to competition. Simply put, there are more providers in the market today. It is also partially due to fewer firms charging on a contingency basis (fees are based on a percentage of client tax savings). According to the IRS, “examiners should closely scrutinize studies performed on contingency fees.” Property owners and their advisors should avoid cost segregation providers charging on a contingency basis because contingency fee arrangements create an incentive for the cost segregation provider to be overly aggressive. Appropriate fees for a cost segregation study will depend on a number of factors, including the size, type and complexity of the property, and the amount of time the study will take. The majority of providers bill on a fixed fee basis.
For those out there who buy purely on price, keep in mind the old adage, “you get what you pay for”. Rarely is the lowest fee associated with the highest value.
There are many things to consider when choosing a cost segregation provider, and the savings produced by these studies certainly afford you the ability to make your decision based on factors other than price. The last thing you want is a cost segregation study that will not stand up to an audit because you chose to save a few bucks.
