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What is a Cost Segregation Study?
A Brief History
Until 1986, real estate owners received reasonable treatment from the IRS regarding depreciation of their holdings. However, in 1986 there was a major overhaul of the IRS tax code that devastated the real estate market by doubling depreciation lives for many types of buildings while also eliminating the tenant lease term rule. The resulting reduced depreciation deduction increased the real estate owner’s income tax liability.
Since this law change, a number of real estate owners, including leasehold improvement owners, have tried to use pre-1986 rules regarding depreciation, usually ending up in tax court, and usually not winning. It wasn’t until 1997 and the landmark Tax Court case, Hospital Corp. of America, Inc. (HCA), that the real estate depreciation tide turned in favor of the taxpayer. In it’s ruling, the Tax Court stated that the 1986 tax law did not change the IRS’s previous definition of a building versus a nonbuilding (more on this definition later). By making this statement, the Tax Court “freed up” 40 years of favorable tax law, rulings, and court cases which are the basis for our MS Consultants, LLC studies. Almost as important as the 1997 HCA ruling, in 1999 the IRS agreed to follow the findings of the HCA case as long as the taxpayer follows the IRS’s specific guidelines regarding Cost Segregation Studies.
In 1997, the IRS made another change that was favorable for real estate and leasehold improvements owners. Prior to 1997, depreciation that had been understated due to prior years’ miscalculations was only recoverable by amending tax returns (if the mistake occurred within the last three years) or was lost forever. In 1997, the IRS finally agreed that deprecation can be confusing, and taxpayers should be allowed to recapture “missed” depreciation. The amount of missed depreciation from prior years can now be taken as an expense during the current year. This change allows MS Consultants to prepare studies on real estate placed in service as far back as 1987. For example, a real estate owner can have a study prepared this year on a building purchased in 1990, and deduct all of the previously missed depreciation on the owner’s current income tax return.
How does a Cost Segregation Study work?
A Cost Segregation Study (CSS) operates on the same principle that most good tax planning relies on – by decreasing current income, you defer income taxes to a later tax period, and gain financially due to the time value of money related to the taxes deferred. Simply put, a tax deduction today is worth more than a tax deduction next year, and worth a lot more than a tax deduction thirty years from now.
Historically, most real estate owners and their accountants have classified real estate projects as “buildings” or “leasehold improvements” and depreciated the costs over 27 to 39 years (these lives apply to most real estate purchased or constructed after 1986).
In contrast, the IRS’ definition of a building is much more specific. The IRS defines a building as a structure with walls, floors, ceilings and a roof. A building includes structural components such as HVAC, plumbing, electric, and other components necessary for the operation and maintenance of the building. (See Section 1.48-1 of the IRS Regulations).
Therefore, by the IRS’ own definition, a building may have nonstructural components installed during construction, or included as part of the purchase, and these will be considered “equipment” or “land improvements”. In most situations, equipment can be depreciated over 5 or 7 years, while the tax life for land improvements is 15 years. An MS Consultants CSS identifies the nonstructural components of an owner’s building, assigns costs to the components, and increases the owner’s depreciation by lowering the component’s tax life. Faster depreciation results in tax savings for the owner much earlier than the usual 27 to 39 years.
The savings can be tremendous – it is not unusual for MS Consultants to reclassify over 30% of a real estate project as nonbuilding – saving literally millions of dollars for our clients. Please contact us to find out how MS Consultants can generate tremendous savings for your Real Estate Owner.