This valuable, yet often overlooked, strategy enables owners to reduce their tax liability and increase cash flow with the use of accelerated depreciations on eligible assets. For many owners, the likelihood of significant tax benefits from a cost segregation study, commonly referred to as "cost seg," warrants filing for an extension until September or October. This will allow ample time to complete the analysis.

Generally speaking, buildings can be depreciated over a 27.5- or 39-year period. But, according to the Internal Revenue Code, certain categories of assets that exist within a building, or surrounding a building, can be depreciated more quickly, over five, seven or 15 years. Reclassifying these eligible assets often serves to accelerate part of the building's tax depreciation, creating a reduced tax liability.

A cost seg study is the tax and engineering analysis that identifies and segregates these eligible assets, assesses their value and determines the resulting asset classes as well as its corresponding depreciation deduction. It takes a team of qualified engineering, accounting and tax experts to conduct a proper analysis because the end results depend on accurate tax, accounting and engineering valuations.

Eligible assets include systems, fixtures and other related elements that are either unnecessary for the operation of the building itself, are decorative or ornamental in nature or are temporary structures. Examples are ornamental lighting or moldings, certain flooring, wall coverings and redundant HVAC systems. The IRS has published detailed guidelines on cost segregation in its Audit Techniques Guide.

Recently, a well-known real estate investment group asked Madison SPECS to execute a cost seg study of its 500-acre office park, which is the largest mixed-use corporate office park in the country. At roughly four million square feet, the site is comprised of office, industrial, research, distribution and manufacturing spaces spread over 11 primary and three support buildings.

In the early stages, Madison SPECS reviewed all of the lease agreements and identified an enormous opportunity for the current owners to take advantage of certain tenant improvements that were made and paid for by the prior landlord. Working collaboratively with the facility's maintenance personnel, Madison SPECS engineers examined the complicated systems of the property--measuring materials and taking hundreds of photos and detailed notes.

The next step was to turn over the data and records to the cost analysts at Madison SPECS to help identify the assets eligible for accelerated depreciation and accurately determine their cost. Due to its sheer size and scope, this property had a wide range of eligible assets. Just a few examples include thousands of linear feet of demountable wall partitions, colossal redundant transformers, an overhead conveyer system and 14 emergency generators as well as entire floors of locker rooms and benches.

The process then moved to Madison SPECS's operations team, where the engineering and tax components of the cost seg study are integrated. Madison SPECS completed the entire study--from the initial discussion to the final report--in three weeks.

Proving extremely successful, this cost seg study thrilled the property owners. The facility's total cost was $46,750,000. Of this, the cost seg study permitted $5,905,781, or 13%, to be reclassified from 39- to five-year Modified Accelerated Cost Recovery System property. Meanwhile, 6%, or $2,925,082, was reclassified to 15-year MACRS property. This reclassification of assets resulted in a net tax benefit of $201,260 in the first year and a $2,266,664 net tax benefit over the first six years.

Madison SPECS recently worked with the owner of a four-story, 130-unit senior living garden apartment complex in California. The complex contained 82 one-bedroom and 48 two-bedroom apartments. As a result of Madison SPECS's cost seg analysis, the owner's first-year tax benefit came to $269,842.

Another example is a 24-building apartment complex with 224 units in Virginia that showed a first-year tax benefit of $497,769 from the cost seg study.

Owners are able recapture understated depreciations for the past construction, renovations or expansions of older properties with a simple change in accounting method. This is known as a "catch-up" adjustment, or I.R.C. Section 481(a) adjustment. Amended tax returns are not required. Instead, a "catch-up" amount can be taken in one year by filing IRS Federal Form 3115 in which the IRS automatically grants consent upon its filing of a timely filed tax return, including extensions.

The bottom line is that cost seg has the potential to save significant dollars for property owners. In today's tumultuous economy, that sounds pretty good.

Eli S. Loenbenberg, CPA, is CEO of Madison SPECS LLC. The views expressed here are the author's own.

Instant Insights /

Reducing Tax Liability

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