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SOLUTIONS FOR TAX PROFESSIONALS AND BUSINESSES

TAX CREDITS • INCENTIVES • COST RECOVERY

CS 101: Overview of Cost Segregation

PRESENTED BY:

Scott Zarret

Director

NATIONWIDE SERVICE Tax Credits · Incentives · Cost Recovery

© KBKG inc 2012

Established in 1999, KBKG is a specialty tax and consulting firm providing nationwide service

• Cost Segregation

• Green Building Deductions

• Enterprise Zone Tax Credits

• Research & Development Tax Credits

Our engineers and tax experts have performed thousands of tax projects resulting in hundreds of millions of dollars in benefits for our clients.

Our goal is to bring value to our clients by providing quality service, building long-term relationships, and ensuring a high standard of professional ethics.

KBKG offers Partnering Opportunities focused on the needs of CPAs and real estate professionals. These opportunities allow our partners to stay focused on what they do best, while allowing them to earn revenue, offer additional services, generate goodwill and expand their business though specialty services.

About KBKG, Inc.


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An alumnus of the University of Maryland in College Park, Maryland

Began my career in the audit & tax department of Reznick, Fedder & Silverman, CPAs, in Bethesda, Maryland.

Over 10 years of CPA, marketing and business development experience within the professional services arena.

Director of KBKG

Frequent contributor to various publications including the Denver Business Journal, Colorado Real Estate Journal and the Colorado Society of CPAs Newsletter, Accounting Today, Dealer Tax Watch and dozens of other publications.

President of CPAacademy.org

Scott Zarret, Director


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CPAs and real estate professionals who are new to Cost Segregation as well as experienced professionals who want a refresher course.

Our goal:

Provide an overview of cost segregation

Share information that will make you more valuable to both yourselves and your real state clients

Who is this class designed for?


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"Cost Segregation Applied” – August 2004

"When it comes to real estate acquisitions, the jewel of cost segregation is that it yields enhanced depreciation deductions. There can be astounding differences in outcomes between using and not using it."

"CPAs should routinely recommend that their clients or employers use cost segregation whenever the expenditures for a structure, including leasehold improvements, equal or exceed $750,000."

“Selecting a firm that uses qualified professionals with years of significant, relevant experience can be an important differentiator in the quality of a cost segregation study.”

Best of Both Worlds” – August 2005

"Combining Cost Segregation and Section 1031 exchanges allows taxpayers to defer the maximum amount of income taxes.“

Quotes AICPA Journal of Accountancy


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Cost Segregation Defined

Case Study

Tax Planning Opportunities

History & Legal Framework / Personal Property Samples

How the IRS Views Cost Segregation

Sample Report

Proposal Process

Wrap Up

Presentation Outline


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COST SEGREGATION DEFINED


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Investors who own commercial and residential rental properties are allowed cost recovery (otherwise known as “depreciation”.)

Depreciation allows a taxpayer to recover the cost of an asset over the period of time (“useful life”) the asset is expected to be able to produce income.

Cost Recovery Defined


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The Internal Revenue Code (IRC) defines depreciation as a deduction for a reasonable allowance for the exhaustion, wear and tear (including an allowance for obsolescence) of property used in a trade or business, or for the production of income.

Before depreciating an asset, you need to know certain information about it, including:

Date placed in service

Cost or other basis *

Property class *

Recovery period *

Cost Recovery Defined (cont)


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A formal engineering process, accepted by the IRS

Identifies building costs and land improvements - traditionally depreciated over 27.5 or 39 years

Re-allocates a significant portion of these “building” costs to asset classes with shorter depreciable lives (accelerated depreciation)

Cost segregation will allow you to properly identify an

asset’s cost basis, property class and recovery period.

What is Cost Segregation?


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Qualifying construction costs from the property should be depreciated over 5, 7, and 15-year lives.

This results in:

Accelerated depreciation deductions

A reduced tax liability

An increase in cash flow

What is Cost Segregation? (cont)


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Cost Segregation accelerates depreciation, it does not increase depreciation.

Total capitalized costs of a building will fully depreciate with or without a cost segregation study.

Time Value of Money

“A dollar today is worth more than a dollar tomorrow”. So therefore an accelerated tax deduction today is worth more than a tax deduction tomorrow.

The longer you hold onto the property, the greater the tax advantage.

Benefit: Accelerated Depreciation Deductions


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Cost Segregation provides your tax

deductions earlier in the life of the building by

“front-loading” the depreciation expense.

This increase in depreciation expense is used

to offset otherwise taxable income which

therefore defers taxes and increases cash

flow.

Benefit: Accelerated Depreciation Deductions


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Immediately after construction or acquisition

Take full advantage of the deductions right away

During Construction (properties larger than $20m)

Buildings already in service

Even when no costing information is available

Following major capital improvements

Leasehold improvements, remodeled property, build outs

After a change in ownership

Estate “step-ups”

When Should a Study be Performed?


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Depend on:

Type of building and improvements

Placed in service date

How much personal property has already been identified

Holding period

Owner’s tax rate

1031 exchange, step-up

Discount rate

Tax Benefits


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Building Type

Apartment Buildings

Retail Stores

Restaurants

Office Buildings

Manufacturing Facilities

R&D

Wineries

Grocery Stores

Hotels

Warehousing

Average

Re-Allocation

20-35%

20-40%

20-45%

10-25%

20-60%

30-60%

20-45%

25-45%

25-45%

10-25%

Other Projects Include: Shopping Malls

Airports

Sports Facilities

Golf Courses & Ranges

Auto Dealerships

Resorts

Healthcare Facilities

Medical Centers

Industrial Buildings

Distribution Centers

Auto Service Centers

And more

What types of properties qualify?


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Every $100,000 of 39-year property reclassified to 5-year or 7-year property generates approximately $18,000 to $22,000 in tax savings.

• Assuming the taxpayer’s tax rate is 41% and their Return on Investment (ROI) factor is 8%

• B = ((1-F)*S)+F

• B = blended rate

• S = state tax rate

• F = federal tax rate

Tax Savings


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Real Property: (27.5 or 39-year S/L)

Land improvements: (15 years / 150% DB)

Ex. sidewalks, fences and docks.

Personal property: (5 or 7 years / 200% DDB)

Ex. furniture, carpeting, appliances, certain fixtures and window treatments.

Land (non-depreciable)

Whatever amount of the purchase price is not accounted for in the three other categories is allocated to land.

o Whenever a land valuation is available, the IRS recommends taxpayers to either use the land valuation from an appraisal or to use the % allocated to land within an appraisal when determining the land's basis.

Real vs. Personal Property


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Under MACRS, a variety of depreciation methods are allowed depending on the life and type of asset.

Straight-line: 27.5 and 39 year property

150%DB: 15 year property

200%DDB: 3, 5 and 7 year property

Must use proper convention for the applicable life and property type.

Depreciation


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To calculate depreciation, taxpayers must use the correct method and proper

recovery period for each asset.

Property (acquired or constructed) generally consists of numerous asset types

with different recovery periods.

Depreciation Table of Class Lives and Recovery Period (R.P. 87-56)


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Depreciation Conventions


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CASE STUDY


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MACRS Tax Rate Comparison


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Before After

39-year

or

27.5-year

Soft Costs

5-year

39-year

or

27.5-year

7-year

15-year Cost Seg

Str

aig

ht L

ine

Str

aig

ht L

ine

Acce

lera

ted

$100k of

39-yr to 5-yr =

$22,000 tax

savings

Accelerated Dep.

Reduced Tax Liability

Increased Cash Flow

Asset Reallocation


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$5M Office Building

Example 1 Current Year Acquisition


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$5M Office Building

Example 2 Prior Year (PY) Acquisition – 5 year (lookback)


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TAX PLANNING OPPORTUNITIES


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Bonus Depreciation / Emergency Economic

Stabilization Act / Section 179

Catch-up Depreciation (form 3115)

Recapture

Leasehold Improvements

1031 Exchanges

Property Tax Issues

Tax Planning & Other Benefits


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American Taxpayer Relief Act was passed on January 2, 2013

Section 179's increased expensing amounts have been extended through 2013. 50% Bonus Depreciation provisions have been extended through the end of 2013 as well (2014 for certain property).

2-year extension allows for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property to have a 15-year depreciation recovery period through the end of 2013.

Tax Relief Act (H.R. 4853) was passed on December 16, 2010

The American Recovery and Reinvestment Act was passed on February 17, 2009.

The Economic Stimulus Act was passed on February 13, 2008.

Brought back 50% bonus depreciation, for a limited time.

100% Bonus Depreciation & Extension of 50% Bonus: Temporary 100% bonus depreciation deduction for qualifying property placed in service between 9/9/10 and 12/31/11. 50% Bonus Depreciation provisions have also been extended through the end of 2013.

Economic Stimulus


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Cost segregation studies reclassify a substantial portion of a building

project from 39 years (or 27 1/2 years in the case of residential income

properties), into five-, seven- and fifteen-year property. In addition to the normal accelerated deductions this creates, the assets

also become eligible for bonus depreciation.

o Therefore, taxpayers constructing or remodeling buildings have even

more incentive to have an engineering-based cost segregation study

performed.

CS will help the taxpayer take full advantage of the bonus depreciation

rules by identifying every constructed asset that qualifies for the shorter

depreciation periods

The 50% bonus deduction means that 50% of the costs of qualified

depreciable property can be taken in the first year as a deduction. In

addition to the fact that you continue to depreciate the remaining 50%

of the balance over the correct lives that were assigned to the asset

Enhance Your Savings with Cost Segregation


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Bonus Depreciation is a mandatory application

unless you choose to elect out

Bonus applies for Alternative Minimum Tax (AMT)

purposes

No income or investment limitation on the allowance

No short-year adjustments for bonus depreciation

Bonus Depreciation Basic Considerations


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Qualified Property is:

Qualified Leasehold Improvements (QLIs)

MACRS property with a GDS recovery period of 20 years or less

Water Utility Property

Computer Software (with the exception of software covered by Section 197 (purchased as part of a business)

Qualified Property is not:

Qualified Restaurant Improvements

Alternative Depreciation System (ADS)

Bonus Depreciation Requirements (cont)


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15 Year Improvement Depreciation Quick Reference


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Definitions


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CHANGE IN ACCOUNTING METHOD


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Rev. Proc. 2002-9 (supersedes Rev. Proc. 99-49)

Permits automatic change in accounting method

Filed in the year the change is elected

o No amended returns required

• If you amend the benefits are based on the prior year tax bracket

Allowed taxpayer to catch up on deductions from previous years as a result of a cost segregation study—but benefit had to be spread over 4 years

Rev. Proc. 2002-19 (supersedes Rev. Proc. 99-49)

Adjustments can be expensed entirely in the year of the change

Tax Topics: Change in Accounting Method Form (3115)


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• Most of the time a 3115 is

used and there is no

“REFUND" unless the

taxpayer overpaid estimated

taxes in the current year.

• The 3115 is a current year

deduction so the benefits are

based on the current year tax

rate

Preparing The Form 3115


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RECAPTURE ISSUES


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Planning opportunity if the value of Section

1245 property has decreased in value

compared to Section 1250 property.

The lower the value assigned to the 1245

property the lower the amount of recapture.

The only other way to mitigate would be to

exchange instead of an outright sale.

Recapture Issues


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1031 EXCHANGES


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Cost Segregation and 1031 Exchanges


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A properly structured §1031 allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes.

IRC §1031 (a)(1) states: "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."

1031 Exchanges


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Defer taxes and therefore improve cash flow

Can be performed on any type of commercial property

Can be used on the same property

Encompass complex areas of tax law and necessitate the use of specialists

Similarities Between Cost Segregation and 1031 Exchanges


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Real vs. Personal Property

State law vs. Federal law

Appreciating tax base (real) vs.

depreciating tax base (personal)

Initial property assessment vs. subsequent

adjustments

Property Tax Issues


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HISTORY AND LEGAL FRAMEWORK


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Cost Segregation has been around since the Investment Tax Credit (ITC) in the 1960’s.

The initial cases were related to whether items related to a structure could qualify for the credit.

The IRS reluctantly agreed that CS does not constitute component depreciation

Action on Decision 1999-008

IRS warned taxpayers that an “accurate” CSS cannot be based on non-contemporaneous records, reconstructed data or taxpayers’ estimates or assumptions that have no supporting records (CCA 199921045).

History of Cost Segregation


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The introduction of the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS) in 1987 eliminated the use of component depreciation - but not cost segregation.

IRS publications 534 and 946 address the depreciation of property for tax purposes. Publication 534 deals with the depreciation of assets placed in service before 1987. Publication 946 deals with depreciating property under the MACRS rules after 1986.

MACRS comprises two systems: General Depreciation System (GDS) and Alternative Depreciation System. GDS will generally apply unless you are required by law or elect to use ADS.

Understanding Asset Identification & Depreciation


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Over 2000 court cases and IRS rulings supporting the use of Cost Segregation

Cases that decided in favor of the taxpayer:

Whiteco Industries, Inc.

o Billboards

Scott Paper Co.

o Electrical distribution systems

Morrison, Inc.

o Kitchen electrical panel boards

Illinois Cereal Mills

o Electrical distribution systems

Hospital Corporation of America

o Wall coverings, electrical systems

Cost Segregation Rulings


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Standards used to determine whether an

asset constitutes §1245 property.

Functional Use Test

o ITC

Permanency Test

o Whiteco

Sole Justification Test

Tests to Determine 1245 Property


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The primary test for determining whether an asset is § 1245 property is to determine whether or not it is a structural component of a building.

If an asset is not a structural component of a building, then it can be considered to be § 1245 personal property.

The structural component determination hinges on what constitutes an inherently permanent structure and how permanently the asset is attached to such a structure.

Factually intensive determination and explains the lack of bright-line tests for segregating property into § 1245 and § 1250 classifications.

Functional Use Test


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The early administrative rulings on ITC focused on a "functional use test" to determine whether an asset constituted § 1245 property.

Evaluated the purpose for which the asset was used.

o For example, if the asset served a function normally attributable to a structural component or permanent structure, it was not treated as tangible personal property even if it could be moved.

Following several conflicting court decisions which addressed the inherent permanency of particular assets, the IRS shifted its focus from the functional use test to an evaluation of factors indicating inherent permanency.

Functional Use Test


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In 1975, the Tax Court, based on analysis of judicial precedent, developed six questions designed to ascertain whether a particular asset qualifies as tangible personal property.

Can the property be moved and has it been moved?

Is the property designed or constructed to remain permanently in place?

Are there circumstances that show that the property may or will have to be moved?

Is the property readily moveable?

How much damage will the property sustain when it is removed?

How is the property affixed to land?

Permanency Test (Whiteco Factors)


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an item may qualify for a lower life even though it is a structural component of a building if it is necessary to meet specific temperature or humidity requirements essential for

the operation of the machinery, or

the processing of materials or foodstuffs

Sole Justification Test


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Hospital Corporation of America Case

109 TC 21 (1997)

The Court ruled that certain costs related

to specific ordinary use equipment (that

otherwise would be viewed as structural)

qualified to be depreciated over the life of

the underlying asset.

Hospital Corp of America vs. Commissioner


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In 1999 the IRS issued a memorandum

in which it acquiesced to the Tax Court

Ruling (199921045).

The determination of whether an asset is a

structural component or tangible personal

property is:

o Facts and circumstances assessment

o No “bright line” test exists

Hospital Corp of America vs. Commissioner


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PERSONAL PROPERTY EXAMPLES


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Track lighting

Wall paneling

Counters

Flooring

Section 1245 Personal Property - examples


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Insulated door

Steel bollards

Special piping

Electrical wiring



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Includes improvements directly to or

added to land, whether such

improvements are section 1245 property or

Section 1250 property, provided such

improvements are depreciable.

Examples of such assets might include:

Hot Tubs

Drainage facilities

Waterways

Docks

Bridges

Shrubbery

Sidewalks

Gazebo

Sewers

Swimming Pool

Fences

Landscaping

Land Improvements


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Issued April 30, 2004 (revised January 20, 2006)

Developed to assist field agents in reviewing Cost Segregation Studies

o Why cost segregation studies are performed for federal income tax purposes

o How cost segregation studies are prepared

o What to look for in the review and examination of these studies

Not intended as an “official IRS pronouncement”

To access the Cost Segregation Audit Techniques Guide go to: http://www.irs.gov/businesses/article/0,,id=134180,00.html

IRS Audit Techniques Guide

http://www.irs.gov/businesses/article/0,,id=134180,00.html


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Cost Segregation Audit Techniques Guide - Table of Contents

Chapters:

Introduction

Legal Framework

Cost Segregation Methodologies

Principal Elements of a Quality Cost Segregation Study and Report

Review and Examination of a Cost Segregation Study

Appendix

o Uniform Capitalization

o Change in Accounting Method

o Depreciation Overview

o Relevant Court Cases

o Statistical Sampling

o Construction Process

o Information Document Requests

Industry Specific Guidance

o Casinos

o Restaurants

o Retail Industries

o Field Directive on Planning and Examination of Cost Segregation Issues in the Biotech/Pharmaceutical Industry

Audit Techniques Guide



















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Detailed Engineering Approach From Actual Cost Records

Detailed Engineering Cost Estimate Approach

Residual Estimation Approach

Survey Or Letter Approach

Sampling or Modeling Approach

“Rule of Thumb” Approach

Cost Segregation Methodologiesa


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Detailed Engineering Approach From Actual Cost Records

Accurate cost allocations

o Per the IRS, “In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation.”

Generally used for new construction where detailed cost records are available:

o Blueprints, specifications, contracts, job reports, change orders, payment requests, invoices are used to determine unit costs

Detailed Engineering Cost Estimate Approach

Generally used for acquisitions where detailed cost records are not available

o Estimates costs determined by published sources

Cost Segregation Methodologies:

Detailed Engineering Approach From Actual

Cost Records


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Residual Estimation Approach

Abbreviated method – only short-lived costs are determined

Residual costs are assigned to long-life assets

Simpler and less accurate than an engineering approach

Survey Or Letter Approach

Contractors and/or subcontractors gather costs

Costs are used in conjunction with all methodologies

Sampling or Modeling Approach

Analyze multiple properties (fast food chains, retail outlets)

Accuracy is suspect – may not be statistically valid

“Rule of Thumb” Approach

An estimate of the percentage generally moved to shorter-lived property, by industry

Other Cost Segregation

Methodologies


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Certification - Identifies the persons (and their credentials) who prepared / signed the report and developed the analysis, opinions and conclusions

Executive Summary - Overview of subject property and study

Narrative Report - Discusses the theory, definitions and rationale behind the study and the detailed property descriptions

Schedule of Assets - Detail of assets and costing methodologies

Schedule of Property Units and Costs -Property segregated into 1245 and 1250 property

Engineering Procedures -Describes engineering procedures and methodology used to determine the cost for each property unit

Statements of Assumptions of Limiting Conditions - Defines the scope and indicates the reports focus, assumptions and inclusions / exclusions from the study

Schedule of Direct and Indirect Costs - Identifies direct and allocated costs, clearly identified and explained

Exhibits - Photographs of assets, lease abstracts, etc.

Principal Elements of a Quality Report

KBKG, INC. COST SEGREGATION SPECIALISTS

Information We Need


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Fees

Prices have dropped significantly over the past several years.

Priced should be based on the complexity of the project

Timeline

A cost segregation study typically takes five to seven weeks to complete.

Fees and timeline


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Per the IRS Audit Techniques Guide, the IRS states the following: “Some firms use contingency fees where cost

information is based primarily on the tax benefits received from a study. Contingency fee arrangements create the incentive to maximize §1245 costs usually through “aggressive” legal interpretations and/or by inappropriate cost or estimation techniques. Accordingly, examiners should closely scrutinize studies performed on contingency fees.”

Contingency Fees


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Commercial Developers RC 179D - Allows you to claim a $1.80 per square foot deduction

for qualified buildings constructed. o Ex. If they build an eligible 100,000SF building they are entitled to $180,000

of Federal deductions.

Architects RC 179D - Architects are entitled to a tax deduction of $1.80 per

square foot of qualified buildings they design, without triggering income.

o Ex. If they designed an eligible building that is 100,000 SF, they get $180,000 of Federal deductions.

Multi-Family Residential Developers & Homebuilders IRC 45L - Allows for a $2,000 tax credit per qualified apartment,

condo unit, or single family home. o Ex. A 50 unit apartment can be eligible for $100,000 of Federal Tax Credits

Green Building Tax Incentives


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CS is experiencing explosive growth

Changes in tax law affect motivation

Many building owners aren’t aware of the benefits

Building owners are changing the way they think about their investment strategies and gaining insight into how they can reap tremendous tax deferral by having a cost segregation study performed.

CS is being marketing more heavily

As the real estate community becomes increasingly educated, more firms are finding effective ways to offer engineering-based cost segregation services to their clients.

Tax and other real estate professionals are well-positioned to offer cost segregation to their clients.

General Industry Overview


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Increased IRS scrutiny of Cost

Segregation

Increased # of engineers to review reports

Disallowing certain assets

Assessing penalties for improper

reclassifications and component values

Conclusion


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Does the company have the appropriate tax background? Do they employ CPAs?

Do they employ engineers?

Do they address tax related abandonment issues?

Are they knowledgeable on issues involved with a 1031 exchange and how it interacts with Cost Segregation?

Do they have the expertise to file, or help you with, the IRS Form 3115 procedures?

Does the cost of the study include time for audit support?

Are they qualified and knowledgeable about all the credits and incentives for Green Building and other Energy Tax incentives?

Things to Consider When Comparing Cost Segregation Services

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