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Or How To Use the IRS to Help Fund Operations and Growth
Restaurant owners who have purchased their own building or tenant improvements are beginning to discover what large commercial property owners have known for several years – that a little-known, widely misunderstood, and IRS-approved tax strategy called cost segregation can enable commercial building owners to defer tens or even hundreds of thousands of dollars in income taxes.
Cost segregation came into being in 1997, with the landmark tax court case, Hospital Corporation of America (HCA) v. IRS 109 TC 21 (1997). Prior to that ruling, the cost of commercial buildings had to be depreciated over 39 years, regardless of the building type or usage. With cost segregation, owners can accelerate the depreciation of qualified non-structural building components into more appropriate timeframes such as five, seven, and fifteen years. This is a significant tax savings: The owner of a $1,000,000 building can often see as much as $75,000 in added bottom line cash flow.
In spite of its value, most building owners have never heard of cost segregation. Many others have only a vague notion of what it is, and little idea of its benefits. Nor has the IRS tried to make taxpayers aware of this ruling. As we all know, the IRS is not in the business of telling taxpayers how to pay the least amount of tax possible.
Although many CPAs have heard about cost segregation, relatively few have suggested it to their clients. One reason in the IRS wants a type of engineering expertise that is rare within the CPA community. Also, until recently cost segregation studies were prohibitively expensive for all but the largest commercial property owners. Over time, a small number of providers have managed to bring fees within reach of owners of smaller properties. As a result, the engineered cost segregation study is slowly beginning to catch on.
How does it work?
In order to take advantage of the IRS ruling, an owner must engage and apply an engineered cost segregation study. This is the process of identifying the building components that qualify for accelerated depreciation. Depending on the type of building and its use, anywhere from 20 to 50 percent of the purchase, construction or leasehold improvement cost can be accelerated. Types of assets that can be reclassified include portions of electrical, plumbing and mechanical systems and numerous other components. For existing buildings, the owner’s accountant submits a form 3115 with the next tax return documenting the change in accounting method. Any accrued benefit is taken immediately, without having to amend previous years’ returns.
The process of performing a cost segregation study is highly technical, and there are no bright line tests for what components can be accelerated. Internal IRS directives make it clear that only those with expertise in the various aspects of commercial construction are qualified to properly identify components and to determine what depreciable life is appropriate for a given component. The required expertise outlined by the IRS includes understanding construction methods and systems, reading blueprints and engineered drawings, and knowing the relevant court cases and private letter IRS rulings. This skill set is a blend of engineering, legal, and specialized tax expertise. The IRS also strongly recommends that the study provider have an “arm’s length” relationship with owners and their accountants. For these reasons, owners are strongly encouraged to seek out a firm that specializes in engineered cost segregation studies and that meets all the necessary qualifications.
Who can benefit?
The IRS ruling applies to anyone who purchased, constructed, renovated or made substantial improvements to a commercial building after January 1, 1986. Those who did so within the last 15 years have the most to gain. Thanks to a 1999 provision of the code, depreciation that should have been allocated in previous years can be taken as an all-at-once deduction on current-year taxes.
The IRS now considers cost segregation to be the correct method for depreciating a commercial property. Building owners, whether they are individuals, ‘C’ or ‘S’ corporations or LLCs, who own – or would like to own – their buildings may well want to consider an engineered cost segregation study. The result could be a significant and immediate increase in cash flow and tax savings.