Cash-flow recovery via cost segregation: Real Estate Articles from Inman News

Cost Segregation: Reduce Your Income Tax + Increase Your Cash Flow
Real estate investors wisely spend a lot of time focusing on price per square foot, ROI, and other key valuation and market parameters; however, it is equally important to consider cash flow and income taxes when buying or selling an investment property and what strategies will diminish the former and increase the latter.

One area that is frequently overlooked when considering cash flow is the impact of properly configured depreciation. Many property owners are not aware that there is a way to accomplish this and are unnecessarily paying too much in taxes each year. Optimal depreciation strategies applied in the first five to 15 years of ownership significantly decrease income taxes, thereby increasing return on investment. This found money could be used to acquire more property, to improve or rehab today or in the future ... it can be directed in an infinite number of ways, provided you keep it in your hands and not in the hands of the IRS.

For example: properly configured depreciation for a $5 million office building results in additional first-year depreciation of $128,000 and net present-value tax savings of $214,000. What could you do with that newly found cash? $51,200. FOUND MONEY! In your account in the same year of the study, no waiting.

So how can you go about maximizing depreciation deductions? The answer is Cost Segregation studies. Cost segregation defined: An engineering-based valuation approach to identifying components within a building that can be reclassified into a much shorter depreciation class than the building itself. Real estate properties (and everything in them) are generally depreciated using a straight-line method over 39 years (27.5 years for residential multifamily properties). The cost segregation specialist maximizes the inherent tax benefit by identifying, classifying and segregating the personal property components of the building, resulting in shorter, more appropriate, depreciable lives of 5, 7 and 15 years. Without this strategy, owners are actually paying taxes before they are due ... unnecessarily.

Items typically reclassified include certain flooring, finish millwork, specialty electrical and plumbing, and land improvements such as asphalt paving, site lighting and underground utilities. The list is extensive as are the benefits to an owner's bottom line.

Specialized engineering valuation firms that focus on cost segregation, such as Cost Recovery Solutions located in Metuchen, New Jersey, with offices in Philadelphia and Fort Lauderdale, provide a specialized blend of knowledge in tax, engineering and construction that allows them to reclassify between 17 percent and 40 percent of a building to shorter recovery periods. The result is a quicker write off of the building and less taxes for the taxpayer.

The cost seg specialist uses an engineering-based approach, as specified by the Internal Revenue Service (IRS), which includes a thorough examination of your property, complete with numerous photos, measurements, and interviews with key personnel who know the history of the building's acquisition and improvements. These steps result in a comprehensive understanding of all potential elements that should be properly included in your study to achieve optimal results. For new construction or rehab projects, cost data, including the contractor's application for payments, change orders, owner-incurred costs, architectural and engineering drawings and disbursements, are examined. For properties that are acquired, the cost seg specialists use their construction cost estimating expertise to overcome the lack of available information.

It is typical for a reputable cost seg firm to provide a free model of projected benefits that will outline what they think you can save. They will also typically commit to a fee and time frame so that you have the necessary information to make a sound judgment as to whether or not the study is appropriate for your situation. All that is needed for this model is a depreciation schedule (or cost if just acquired) and a brief property description. CRS provides a 3-page model with projected increases in cash flow and additional depreciation for the first 15 years.

Do you have an existing building that might be a candidate for a study? No problem. A retroactive study can be performed without the problems associated with amending prior year tax returns or IRS approval. Neither is needed. You can claim the difference between the allowed depreciation and what you actually claimed in prior years all on your current tax return, which would mean big tax savings for you in the same year, no waiting.

You can also perform these studies for property that has been acquired as part of an estate transfer where the property has a stepped-up basis in the hands of the current owner.

Cost seg. also ties in well with a §1031 Like Kind Exchange. The property received is eligible to benefit from a study subject to meeting certain qualifications.

Many real estate owners assume their accountants are correctly maximizing depreciation of their properties. The reality is that many are not claiming the maximum allowable depreciation deduction because they overlook the benefits of a Cost Segregation study, resulting in a 'pre-payment' of taxes not due for several years.

To determine if a cost segregation study is appropriate for your portfolio, ask yourself the following questions: Is the total cost of my building (land excluded) at least $1,000,000? Have I purchased, constructed or renovated the property in the past 12 years? Do I plan on retaining this property for at least the next few years? Do I have net income that is currently taxed? Cost segregation will reduce your income taxes and increase your cash flow and return on investment if you can answer "yes" to these questions.

--Submitted by Greg Hartigan