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Introduction |
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1999 was a great year for people who own real
estate, especially those who own apartment buildings. Why?
For one, in an IRS legal memorandum issued in April 1999 the IRS
finally acquiesced on allowing taxpayers to segregate various
building costs into shorter depreciable lives other than the
27.5 years (via a process called a Cost
Segregation Study). In addition, in another
memorandum, the IRS acknowledged that personal property such as
furniture and fixtures, and appliances should be depreciated
over a 5 year recovery period and not 7 years as included in the
instructions for Federal Form 4562 “Depreciation and
Amortization.” |
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What
Cost Segregation Studies Are All About |
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Apartment buildings normally consist not only of land, bricks,
and mortar, but such other items as land improvements (storm
sewers, curbs and sidewalks, etc.) and personal property (VCT
flooring, kitchen cabinets, etc.). While the brick and
mortar are subject to a 27.5 year recovery period, land
improvements qualify for a 15-year recovery period and personal
property qualifies for a 5-year recovery period. If land
improvements and personal property can be identified and
segregated from the bricks and mortar, they can be separately
depreciated over their shorter recovery periods. A Cost
Segregation Study is the process for accomplishing the above.
For an apartment building approximately 20%-30% of the total
costs can be segregated into land improvements and personal
property. |
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Sounds
Easy |
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Normally when someone purchases an apartment
building, the only items broken out in the corresponding
depreciation schedules are land (non-depreciable), buildings
(27.5 year recovery period) and a nominal amount for personal
property (5 year recovery period). Why? Because a
qualified cost segregation professional was not hired to perform
a study. If you have constructed a building, some
additional items may have been broken out on the corresponding
depreciation schedules as compared to a “purchased”
building, but generally construction invoices alone are not
sufficient to breakout land improvements and personal property
to maximize accelerated depreciation deductions. |
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How an
Apartment Owner Wins
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Any apartment building purchased,
constructed, or improved since 1987 is eligible for a
Cost Segregation Study.
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By accelerating depreciation, you lower your
taxable income (or increase your loss) which saves you current
year tax dollars, thereby increasing cash flow by the tax
savings.
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The net present value of the increased cash
flow is about $200,000 for every $1 million of property that
is reclassified to obtain faster deprecation. As an
example, for a $2 million apartment building this would amount
to approximately $100,000.
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In most instances, it is not
necessary to amend prior year tax returns. The change is
prospective by filing Federal Form 3115 “Application for
Change in Accounting Method” and there is no filing fee.
Basically the amount of omitted depreciation from prior years
is taken ratably as an expense over a 4-year period.
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Your savings in most cases will be at least
10 times the cost of having a segregation study completed.
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Things
To Be Aware Of
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The IRS requires that a Cost Segregation
Study be completed by a qualified professional such as an
appraiser, engineer, architect, or construction estimator.
A CPA is generally not qualified.
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The IRS does not allow for breakouts based
on percentages. |
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Conclusion |
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With personal maximum federal tax rates at a
marginal rate of 41% and some state tax rates at 7%, a Cost
Segregation Study is an extremely effective tool to lower
taxable income without expending cash (except for the study
fee). Think of it this way - you get to hold onto the
government’s money for 15 years interest free and repay it
over years 16 to 27 without interest. But don’t be
fooled - isn’t it your money anyway?
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About the Author
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Phil
Mann, Managing Director at Costsegs is
considered a national expert in the field of Cost Segregation
Studies. His clientele includes large real estate developers,
owners of single use buildings and many Certified Public
Accounting firms throughout the United States. In addition to
participating in hundred's of studies, he is a regular speaker
at real estate and accounting seminars and has had numerous
articles published in industry trade publications.
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