New HVAC Hotel & Apartment Technology Obtains Large EPAct Tax Incentives
Written by Charles R. Goulding, Andrea Albanese, and Jacob Goldman; Energy Tax Savers Inc., The EPAct 179D Experts.
New HVAC technology called VRV (Variable Refrigerant Volume system), also known as VRF (Variable Refrigerant Flow), is substantially reducing hotel and apartment building energy expenses.
This new technology began to mainstream into the US market after the enactment of the Energy Policy Act and is now being widely recommended by the architecture, engineering, and HVAC industries.
The EPAct Section 179D Tax Opportunities
Pursuant to Energy Policy Act (EPAct) Section 179D, VRV building owners making qualifying energy-reducing investments in their new or existing locations can obtain immediate tax deductions of up to $1.80 per square foot.
If the building project doesn’t qualify for the maximum EPAct Section 179D $1.80 per square foot immediate tax deduction, there are tax deductions of up to $0.60 per square foot for each of the three major building subsystems: lighting, HVAC (heating, ventilating, and air conditioning), and the building envelope. The building envelope is every item on the building’s exterior perimeter that touches the outside world including roof, walls, insulation, doors, windows and foundation.
VRV Technology Description
VRF/VRV is an air conditioning system most efficient for commercial buildings because of the ability to individualize control for different zones/rooms, whereas conventional systems condition a building as a whole. The system is very beneficial for buildings with varying cooling needs and different zones.
In particular, hotels, apartments, schools, and office buildings would get the most benefit from this system as individuals want to be able to control the temperature in their area. Individual control in VRF/VRV systems creates energy efficiency and allows for flexibility in building design.
The Japanese Manufacturers
First utilized in Japan over 20 years ago, VRF/VRV units are now marketed in the US by two large Japanese manufacturers, namely Mitsubishi and Daikin McQuay. As new entrants, both companies chose to locate thier US headquarters in two major warmer temperature markets, utilizing large amounts of cooling, namely Dalls, Texas and Atlanta, Georgia.
Apartment HVAC Replacement
With apartments it is the tenant that bears the utility costs related to HVAC. New benchmarking rules in major apartment markets, including California, New York City, Washington, D.C., Austin, and Seattle, will soon provide large amounts of data related to current apartment energy costs(1).
Presumably the Atlanta and Dallas markets where the two US VRF/VRV sellers are headquartered will quickly become aware of the magnitude of energy savings.
Hotel HVAC Tax Savings
The timing for this cost saving technology is excellent for the hotel category since the industry is in the midst of a rapid economic recovery. THe hotel industry was decimated during the economic downturn and has since reorganized.
During the economic downturn necessary HVAC replacements wer defined and are now being addressed. Often hotel investment groups own multiple properties so if they are pleased with VRF/VRV technology incentives, they will replicate it across their hotel portfolio.
Substantial Energy Cost Savings
For both hotels and apartments building HVAC is the largest energy cost item. VRF/VRV’s will annually reduce total energy costs for these two markets by at least 20% and may reduce current building energy costs by as much as 40%.
Many hotels and apartment buildings are currently installing LED and other energy efficient light technoilogies and the total energy cost savings from both measures can often exceed 50%.
Conclusion
VRV HVAC technology is rapidly being introduced into the US market with the help of large EPAct tax incentives. An EPAct technology that reduces apartment tennat cost is welcome on the market and the recovering hotel market is perfectly suitable for this opportunity.
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Charles R. Goulding, Attorney/CPA is the President of Energy Tax Savers Inc., The EPAct 179D Experts, an interdisciplinary tax and engineering firm that specializes in the energy-efficient aspects of buildings.
Andrea Albanese is an Analyst at Energy Tax Savers Inc., The EPAct 179D Experts.
Jacob Goldman, LEED AP, is an Engineer and Tax Consultant at Energy Tax Savers Inc., The EPAct 179D Experts.
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(1) See Goulding, Charles, Goldman, Jacob, & Most, Joseph. “Using EPAct Incentives to Enhance New Mandatory Building Energy Disclosure Requirements.” Corporate Business Taxation Monthly. October 2010. Page 11-14.
LED Lighting Can Play a Key Role in Securing EPAct Tax Benefits
Written by Charles R. Goulding, Raymond Kumar, and Jennifer Pariante; Energy Tax Savers Inc., The EPAct 179D Experts.
At the IMARK 2011 Energy Summit held on November 16-17 in Chicago, Illinois, a panel of senior lighting executives from Acuity Brands, GE Lighting, Hubbell Lighting, OSRAM SYLVANIA and Philips Lighting agreed that the fastest growing market segments for the adaption of LED lighting applications are:
1) Office buildings
2) Hospitality industry (hotels and restaurants)
3) Retail stores
The article explains how to optimize the Energy Policy Act (EPAct) tax opportunities related to these three important vertical market categories.
The EPAct Section 179D Tax Opportunities
Pursuant to Energy Policy Act (EPAct) Section 179D, facility owners making qualifying energy-reducing investments in their new or existing locations can obtain immediate tax deductions of up to $1.80 per square foot. If the building project doesn’t qualify for the maximum EPAct Section 179D $1.80 per square foot immediate tax deduction, there are tax deductions of up to $0.60 per square foot for each of the three major building subsystems: lighting, HVAC (heating, ventilating and air conditioning) and the building envelope. The building envelope is every item on the building’s exterior perimeter that touches the outside world including roof, walls, insulation, doors, windows and foundation.
EPAct Tax Deduction Wattage Targets for the Three Major Market Segments
The following table presents the EPAct wattage targets for office buildings, the hospitality categories of hotels and restaurants, and retail. Tax deductions start wattages at 25 percent more efficient than ASHRAE 90.1.2001 and the full deduction is achieved at 40 percent or better.
Office Buildings
Office buildings are excellent EPAct tax deduction candidates since the 0.78 watts per square maximum tax deduction wattage target is challenging for offices to meet with any lighting technology other than low-wattage LEDs. The country’s largest office buildings tend to be in major cities, many of which have recently enacted public benchmarking laws. These laws, generally applicable for buildings exceeding 50,000 square feet, compare building energy use by building category and assign a percentile. Landlords in the jurisdictions with benchmarking laws including California, New York City, Washington D.C., Austin, and Seattle, are moving quickly to make certain that they are not in the bottom 50 percentile. One of the easiest ways to measurably improve one’s rating is to install energy-efficient lighting, particularly LEDs. Office buildings with very energy-efficient HVAC and LEED certification may be platformed for larger EPAct tax deductions which can be used to offset the high cost of LED lighting.
Hospitality/Hotels
Hotels obtain special privileges under the EPAct tax provisions in that guest rooms are not subject to the tax bi-level switching rule and centralized HVAC is favored over individual room HVAC units. The hotel industry has reorganized after the economic downturn, and new owners are moving quickly to renovate hotels that, in many cases, have long deferred retrofit needs. LED lighting is particularly suitable for hotel guest room interior packages, which typically involve bathrooms, desk lamps, free-standing lamps and bed lighting. Historically, many of these applications used incandescent lamps which are now being phased out by law for the period of 2012 through 2014.
Restaurants
Like hotels, restaurants were adversely impacted by the economic downtrend. Many independent restaurants went out of business and the national and regional chains have gained market share. The large chains are cost containment experts and they standardize lighting design applications. Powerful low-wattage LED lighting is particularly suitable for restaurant design themes. LED lighting enables a much smaller lightweight lighting fixture, which saves these restaurants interior ceiling costs and expands ceiling design options.
Retail
Facing the ever-growing onslaught of nimble competitors and the Internet, retailers must reduce operating costs and in many cases seek to become centers of attraction. LED lighting greatly reduces ongoing operating costs and focused beams of LED lighting are ideal for emphasizing specific merchandise offerings.
Conclusion
LED lighting is now mainstreaming into the major building categories including the three major building categories described above. Informed tax advisors can help their property owners get a better economic return and accelerate these cost savings and business enhancement opportunities.
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Charles R. Goulding, Attorney/CPA is the President of Energy Tax Savers Inc., The EPAct 179D Experts, an interdisciplinary tax and engineering firm that specializes in the energy-efficient aspects of buildings.
Raymond Kumar, CPA is an Analyst at Energy Tax Savers Inc., The EPAct 179D Experts.
Jennifer Pariante is an Analyst at Energy Tax Savers Inc., The EPAct 179D Experts.
This article originally appeared in the February 2012 issue of IMARK Now.
ASCSP Comments on AmeriSouth XXXII., Tax Court Memo 2012-67
Contributing Authors: Gian Pazzia, CCSP; John Hoffman, CCSP; Jeffrey Shilling, CCSP
Summary
In the recently released AmeriSouth XXXII., Tax Court Memo 2012-67, the IRS makes its first meaningful strike in its attempt to marginalize the benefits of cost segregation studies for residential rental property. For many taxpayers and CPAs, this is a complete surprise. However, ASCSP members have known for over a year that this was likely to happen. The IRS seems to have made a coordinated national effort with regards to the classification of assets in residential rental property. Although there are currently numerous IRS exams underway involving depreciation of apartments, the IRS had yet to establish formal case law directly on point with its position on apartments. Further, the IRS warned cost segregation professionals of this position at an ASCSP National Conference and indicated they were going to release a Cost Segregation Industry Directive specific to the residential rental industry. This Directive has yet to be published. ASCSP believes that, much like early case law from the Investment Tax Credit era, just because this specific Tax Court Memo was unfavorable, it does not mean future tax court rulings on the same issues will be consistent. ASCSP provides its opinions below on several items disputed in this case. Further, this case emphasizes the importance of using a Certified or Senior Member of the American Society of Cost Segregation Professionals to ensure the taxpayer is aware of all current industry developments.
Facts
AmeriSouth XXXII, Ltd. acquired an apartment complex in 2003 for $10.25 million. The property was originally built in 1970. As soon as AmeriSouth bought the property, it began a $2 million renovation of the apartments that included replacing cabinets and countertops, dishwashers, garbage disposals, vent hoods, and kitchen sinks. The cost segregation study results were reported on the originally filed tax return for 2003. Roughly 33% of the property was reclassified into categories with 5 or 15 year tax lives. The components at issue include:
- site prepartion and earthwork
- water-distribution system
- sanitary-sewer system
- gas line
- site electric
- special HVAC
- special plumbing
- finish carpentry
- millwork
- interior windows and mirrors
- special painting
AmeriSouth sold the property about the time the case was tried, and stopped responding to communications from the Court, the Commissioner, and even its own counsel. Because of AmeriSouth’s lack of responsiveness, their lawyers withdrew from the case and left the taxpayer representing itself. The case could have been dismissed entirely, but because AmeriSouth didn’t file a post trial brief, the Court deemed any factual matters not otherwise contested to be conceded.
ASCSP Commentary
ASCSP understands that some of positions taken in this cost segregation study are considered somewhat aggressive by most experts. Based on the TC Memo, it also appears there was poor reference material available to substantiate the asset classifications used. A critical factor in this case was that the taxpayer had no interest in defending themselves, effectively giving the IRS a free pass to present their position on many issues without being challenged. In essence, this is the perfect storm for the multi-family industry caused in part by a taxpayer who didn’t resolve the issues at appeals and then essentially gave up when the case went to tax court. It is important to note that this was a Tax Court Memo, and is technically not authority, but that will not prevent the IRS from referencing this during future exams of a cost segregation studies.
We believe one of the most significant issues contested and considered by the Court relates to the appropriate comparison benchmark for an apartment. Should the Court look to see if the items in question relate to the operation and maintenance of a typical apartment building, or to the operation and maintenance of a generic shell building? The Court rationalized that the type of building does matter. ASCSP does not agree with the Court in this critical decision. While it is true that residential rental property enjoys a 27.5 year life versus 39 years for non-residential real property, the leap from building to apartment building seems to be a stretch and we are not convinced that the commissioner would have been successful if the argument had been opposed. We note if this principle is applied to a 15 year service station (asset class 57.1), it would conflict with existing case law that supports personal property classification in service stations. The same can be said for 20 year farm buildings and 15 year restaurant property. Nonetheless, if this argument holds up in future cases, it could have widespread consequences. Below are ASCSP’s comments specific to items held to be real property by the Court.
Site Utilities – Denied as 15 year property. Site utilities are outlined in several previously issued IRS Directives as 1250 Real Property when they relate to a typical building, and we agree. While ASCSP understands methodical allocations of site utilities may be appropriate in some cases, it is hard to argue an apartment building’s gas, water, sewer, and electric service does not relate to the overall operation and maintenance of a building as described in the definition of a structural component found in §1.48-1(e)(2).
Special HVAC – Partially denied as 5 year property. The venting connected to the stove hoods was not allowed because the Court was not convinced that they serve only the stoves. They rationalized that the stove hoods can also serve to remove odors and heat from beyond the stovetop. ASCSP disagrees and believes that if proper case law was referenced, the Court would have allowed these items as 5 year property. Serving as ventilation for the building is merely incidental to its primary function of servicing the stove. Venting serving the dryer was allowed as personal property.
Special Plumbing – Denied as 5 year property. Interestingly, the tax Court considered that AmeriSouth did not intend to periodically replace or plan to replace sinks after the 2003 renovation. While the intent to replace an item is relevant for purposes of determining Repair vs. Capitalization, it generally is not considered when determining the appropriate tax life of an asset. ASCSP also notes that the Court cited the accessory test early in this case but failed to apply such test to any of the items in question. One can argue that kitchen sinks and plumbing are accessory to and necessary for the business of renting apartments.
Ceiling fans and Lights – Denied as 5 year property. ASCSP believes this would have been ruled 5 year tangible personal property if AmeriSouth argued that the lighting provided by these combination light-fans serves to provide ambiance and only incidentally serves as general lighting. The fans are not structural components to the property.
Wiring – Denied as 5 year property. ASCSP believes this also would have been ruled 5 year tangible personal property if AmeriSouth showed that the wiring supplied power for the appliances. The Court stated there was no evidence showing such.
Electric Panels – Denied as 5 year property. Quite simply, if a proper electrical load calculation was conducted and documented between specific equipment and the overall requirements of the building, ASCSP believes this item would have been ruled 5 year tangible personal property. This has been proven in the Scott Paper case.
Millwork and Finish Carpentry – Denied as 5 year property. The Court stated that the proper classification of the cabinetry is strictly an issue of their permanence and implied the same for the finish carpentry. ASCSP has obtained information from unpublished resources that the general contractor who testified was not prepared to explain the steps required to remove these items and not prepared to address the six Whiteco Factors. ASCSP believes the Court would have a different opinion if the permanence of these items was explained by the taxpayer in the context of the Whiteco Case. The vast majority of all kitchen cabinetry in modern apartments is easily removable and reusable.
Mirrors – Denied as 5 year property. ASCSP believes if proper case law was referenced, the Court would have allowed these items as tangible personal property. The Court did not dispute that the mirrors are removable. However, when AmeriSouth’s former attorney called for testimony that the mirrors were decorative, their own witness stated the dining-room mirrors had “no function,” which actually supports the IRS position. I wonder if the judge scratched his head at this point in confusion and wondered which side this witness was arguing for.
Closing
The story of this case is that poor preparation and documentation allowed the IRS to get their positions on the record with circumstances that favored them before the case even started. Unfortunately, according to our inside member resources this case will not be appealed as the taxpayer has no interest in the property anymore. This case emphasizes the risks of not using a Certified or Senior member of ASCSP to conduct these studies. Before choosing one provider over another, check their credentials at http://www.ascsp.org/.
A fellow ASCSP member is in the process of assisting another tax payer/apartment owner that expects to be taking the same issues to tax court. We believe the outcome of that case will be much more relevant to the issues at hand. We will be closely monitoring developments in this area. If you are a taxpayer/owner of apartments and would like to discuss these issues further, please contact a member of the ASCSP. ASCSP is committed to supporting taxpayers that are willing to bring this issue to tax court.
“No-Show” Taxpayer Loses in Tax Court
While the title of this article probably invokes a response from the reader such as “well – that’s a no-brainer”, that is exactly what happened in the case of AmeriSouth XXXII, Ltd v. Commissioner of Internal Revenue. The recently released T.C. Memo 2012-67 has caused quite a stir within the accounting and cost segregation community.
Background
AmeriSouth acquired an apartment complex in 2003 for $10.25 million. Immediately following acquisition, AmeriSouth proceeded to renovate the property, incurring costs in the area of $2.0 million. AmeriSouth engaged the services of a cost segregation firm that took the position that $3.4 million could be classified in 5 and 15-year lives for depreciation purposes. The IRS disagreed with the taxpayer’s position and the taxpayer filed a petition to challenge the Commissioner’s adjustments.
Shortly thereafter, AmeriSouth sold the property and stopped communicating with the court as well as its own attorneys. The situation became so bad that the court permitted the AmeriSouth attorneys to withdraw from the case. When asked to file a post trial brief, AmeriSouth ignored the request. Perhaps they assumed that everything would just “go away”. Unfortunately for AmeriSouth, that would not be the case and the process went on without them.
Court’s Observations
On the surface, it would appear as if the cost segregation consultant made some serious errors and was overly aggressive with some of their interpretations in conducting the cost segregation study. Further, according to the Court, the consultant did not demonstrate sufficient evaluation, validation or substantiation of many assets they called “special use”. The Court also considered the IRS expert witness as being more reliable than the taxpayer’s consultant in recreating costs using the consultant’s own work papers (which strangely were not entered into evidence) citing that it was an attempt to undermine the Commissioner’s characterization of what they held.
The Details
The consultant missed the mark on many assets and did not provide the appropriate level of detail upon which to provide a convincing argument to the Tax Court. Some items include the following:
- Water Distribution Systems
- Sanitary Sewers
- Site Electric
- “Special HVAC and Plumbing”
- Interior Millwork
- “Special Painting”
Bedford’s Observation and Commentary
In several instances, the cost segregation consultant made some serious errors with their interpretation of relevant tax law, court cases and Revenue Procedures in preparing their study and assigned incorrect recovery periods to certain assets. Other than these errors, this case underscores the importance of engineering-based studies conducted and written by the same qualified individual. Cost segregation scope and methodology is critical – especially on acquired properties, as was the case in AmeriSouth.
Additional documentation supporting the consultant’s position regarding “special electrical” might have included actual photographs of electrical panels, and devices with actual load-based electrical calculations might have provided a more defensible position. Similarly, photographic documentation and specific delineation of appliance connections could have supported those assets having 5-year lives. Concise and accurate descriptions of these assets are always beneficial. Simply labeling something as being “special” has no relevance whatsoever.
While it is difficult to determine the credentials of the person who conducted the on-site evaluation and ensuing engineering analyses (if any), it is safe to assume that the report did not stand up to IRS scrutiny as written. Given the taxpayer’s unwillingness to follow procedures, coupled with a series of events that lead up to this decision, it is no wonder that the IRS got exactly what they wanted. The good news is that a comprehensive cost segregation study conducted by a qualified individual will be able to withstand any scrutiny by the IRS. Of course, when challenged by the IRS, the taxpayer and their consultant should actually have an opportunity for their day in court. The results could have been different on a number of items had AmeriSouth actually shown up.
IRS Modifies Energy Reduction Thresholds for 179D Deductions
On February 24, 2012, the IRS issued Notice 2012-22 which modifies the thresholds for various building component energy efficiencies in support of the § 179D deduction pursuant to EPAct 2005.
By way of reference, tax payers may be entitled to a deduction of up to $1.80 per square foot if certain energy savings are realized. The calculations for the deductions are based on lighting, HVAC and building envelope performance standards with the related deductions available for newly constructed or renovated properties. While these incentives have been around since 2005, there have been a couple of modifications over the years.
Traditionally, it has been relatively easy to meet the standards for lighting. It has been more difficult now however, to meet the qualifying thresholds for HVAC and building envelope. IRS Notice 2012-22 now reduces the thresholds for HVAC and building envelope, making it perhaps a bit easier to qualify for deductions associated with these elements. While the adjustment in the thresholds requires for lighting to “pick up the slack”, we feel that ongoing advancements in lighting technology will easily enable taxpayers to still meet the lighting thresholds and create a better chance of meeting the other two thresholds.
As with everything in the tax world, the actual strategy and ensuing results will be based on “facts and circumstances”. If you or your clients have recently constructed or renovated a facility, it may make sense to determine if you could benefit from a study to enable you to take advantage of this valuable tax deduction.
For more information, please contact your local Bedford representative.
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.
