[IMGCAP(1)]For the first time in 15 years, cost segregation services have made Accounting Today’s list of Top Niche services for increasing business, putting engineering studies at the top of the charts in terms of important consulting services for 2014. So what’s driving this sudden attention and popularity?
The answer is simple. The "next generation” cost segregation study has become the most powerful tax tool for real estate clients as a result of the newly revised tangible property regulations (T-Regs) that were passed in late 2013 and early 2014.
This “next generation” cost segregation study has captured the attention of the CPA community because CPAs have always known that a dollar in their client's hand today is worth more than the promise of a dollar tomorrow. The ability for CPAs to assist clients in reducing their tax liability was greatly improved in April 1999. At that time, the IRS issued a legal memorandum allowing taxpayers to segregate various building costs into shorter depreciable lives outside of the standard 39 or 27.5 year class life via a process called Cost Segregation. This was the genesis of the “old school” cost segregation study.
Throughout recent years, the process, application and value of cost segregation have steadily increased. How does the “old school” cost segregation study differ from the “next generation” version?
A simple chart below shows the differences:
Accelerated depreciation through identifying 1245 property vs. 1250 property, land improvements and tenant improvements.
Energy tax deduction (179D) for heating and cooling systems;
Energy tax deduction (179D) for lighting systems;
Energy tax deduction (179D) for building envelope;
Dispositions for undepreciated and retired assets per Treasury Regulation (TR) 1.1168(i)-8 MACRS, or modified accelerated cost recovery system;
Expense of undepreciated basis of property subject to qualified repair per TR 1.162-4;
Expense undepreciated basis subject to routine maintenance per TR 1.263(a) 3(i);
Manage and minimize recapture upon property sales;
Identify and recognize units of property and interdependent systems as defined under the recently issued T-Regs; and
Bonus depreciation for reclassified assets.
These differences reflect the value of cost segregation to CPAs and their clients as a top consulting service. The use of “next generation” cost segregation studies has helped many firms attract new clients, retain existing clients and secure consistent revenue growth and firm expansion.
Importance of Cost Segregation Cost Studies
I asked Allan Koltin, CEO of Koltin Consulting, if he was surprised by the importance that CPA firms are placing on cost segregation consulting services. He responded, “In visiting my CPA clients over the past month, they are all indicating that the new regulation changes have allowed them to thrive in terms of using cost segregation studies to generate strong revenue while attracting new clients.” He added, “Cost segregation and the related tangible property studies are clearly becoming mainstream in the accounting industry. It is typical to see a relevant consulting service being adopted by the five percent innovative CPA firms in the industry and then the trickle effect happens slowly as the other firms see the importance over a decade.”
For a more complete understanding, let’s go back to the genesis of the “old school” cost segregation. The 1999 IRS memorandums were significant because the building does not only consist of walls, roof and interior rooms, but also land improvements (storm sewers, curbs and sidewalks, parking lots, swimming pools, landscaping, etc.) and personal property (flooring, interior finishes, decorative lighting, kitchens, interior glass and electrical wiring for appliances, etc.).
As I mentioned, the “old school” report helped clients accelerate depreciation of their buildings.
The memorandums were clear in that a typical property’s structure is subject to a 39-year recovery period, land improvements are subject to 15-year recovery period, and certain other building components qualify as personal property with a five- to seven-year recovery period. The IRS allows the componentization of buildings for accelerated tax depreciation through the process of a cost segregation study to identify land improvements and personal property that can be separately depreciated over the shorter recovery period. The average commercial building owner will realize approximately 25 to 35 percent of the total costs of their building as shorter class life depreciable assets. This can translate into major tax savings and increase cash flow for savvy real estate investors.
There are also great benefits for clients who have purchased buildings since 1986. The accelerated benefits are not lost for real estate owners who have purchased real estate in a previous tax period. Once a taxpayer files two federal income tax returns using a specific depreciable or non-depreciable life for a particular asset, an accounting method has been adopted for that asset for federal income tax purposes. Prior to the issuance of Rev. Proc. 96-31—the predecessor of Rev. Proc. 97-37, Rev. Proc. 98-60 and now Rev. Proc. 99-49—there was no procedure for an automatic change of accounting method for an asset that erroneously was being depreciated over too long a life or not depreciated at all.
Since depreciation is a non-cash flow item, application of this Revenue Ruling could provide a significant impact on this year’s tax return. For example, a substantial tax benefit is achieved in the case where depreciation has not been taken on a building constructed for $8 million with eligible improvements of $2 million and placed in service on Jan. 1, 2000. The cumulative depreciation of $1,114,200 that was not taken previously can now be deducted in the first year of change. Additionally, the balance of the depreciable assets continues to be depreciated over their remaining life, providing an after tax present value benefit of $600,000.
Automatic Change of Accounting Method
Rev. Proc. 87-56 provides the taxpayer with general depreciation guidelines for use in both a cost segregation study and/or change of accounting method. Rev. Proc. 99-49 provides that a taxpayer may file for an automatic change of accounting method for an asset for which depreciation was not taken, or for which depreciation claimed was less than the allowable amount. The amount of “missed depreciation” from the date the asset was placed in service (the Section 481(a) adjustment) can be deducted in the first year of change.
The benefits of this procedure were solidified by the US Tax Court decision in Hospital Corporation of America. In a pro-taxpayer decision, the Tax Court narrowly defined what is considered “real property” for income tax purposes.
So now we have a historic background to the “old school” study, and we have a glimpse of the “next generation” study. Let’s get into the specifics of the changing benefits of these engineering studies that are causing such a commotion with CPAs.
The new issuance of the T-Regs in regard to repair and maintenance expensing rules dictates the necessity for the full deconstruction of 1250 property with a proper cost segregation study to allow future retirement of assets.
The new issuance of these regulations for expensing versus capitalization shows that the IRS recognizes that property owners who make renovations to the structural 1250 assets of their facility must have a proper engineering study to allow the retirement expense for the abandoned property.
A Look Back
This logic also applies retrospectively. A quality engineering report must look at a building’s assets that are no longer in service as determined through the review of the blueprints, tax schedules and an engineering site visit. An audit of a client’s existing facility will allow a determination of whether assets within the building are currently on the client’s depreciation schedule which should have been disposed of from renovations and/or tenant change-overs in which the assets were disposed with no salvage value.
The next generation report should always include an engineering analysis that summarizes the remaining undepreciated basis of a building’s components subject to expense as abandonment per temporary Treasury Regulations 1.1168 (i)-8 for disposition of MACRS property.
For manufacturing, warehousing, distribution, automated material handling, service industries or clients with similar activities, identifying “functionally independent” machinery or equipment used in the performance in their business activities can make the difference between having to capitalize repairs to these systems. An engineering-based cost segregation study can identify these functionally independent systems and plant property. Once defined, the taxpayer can write off retired assets from their books in the year they were removed from the property, and in some cases, perform a look-back study to clean up currently depreciated assets that no longer exist.
The purpose of conducting a detailed engineering cost segregation report on an existing facility should not only be to reclassify short-term class lives for 1245 property for depreciation acceleration. It also should now be detailed to include total deconstruction and unit price valuation of all structural property to take advantage of the new 263a regulations that allow a property owner to expense the retirement of 1245 structural property throughout the life of the ownership of such property. A properly IRS-compliant study will have an engineering-based unit price for each structural component that includes engineering expertise valuation of the condition of the component, replacement cost of the component removed and aging factors.
The next generation study must also include a detailed engineering analysis of the units of property, or UOPs, for the entire building to make a determination of building components placed into service that are deemed to be repairs and maintenance to be expensed under 263a guidance.
The chart below shows a sample of the assets that would be typical in a new-generation report where assets were actually maintaining normal operations within the facility, and without which the spaces would have been left inoperable. A physical engineering analysis would determine whether the building’s assets were merely replacement of nonperforming assets still being depreciated. If the engineering inspection shows any assets capitalized were to serve to maintain the existing function of the facility, the remaining undepreciated balance would be depreciated. The sample chart below summarizes the engineering tax determination of remaining undepreciated basis subject to expense as qualified repair per Sec 162, Treasury Regulations 1.162-4.
The engineering process to perform such an analysis is outlined in the below tables, as follows:
This engineering process is done under the newly defined IRS Unit of Property engineering division listed below:
Definition of Building Systems (UOP)
Heating, ventilation and air conditioning, or HVAC, systems;
Fire protection and alarm systems;
Gas distribution systems; and
Any other structural components identified in the published guidelines (building envelope).
The next-generation report also needs to capture the remaining undepreciated basis subject to expense as qualified routine maintenance per Sec 263(a), Treasury Regulations 1.263(a) 3(i). This is an often-overlooked engineering process that can yield significant tax deductions for the real estate client.
The next-generation study must also determine whether the real estate client designed or renovated energy efficient lighting, heating and cooling systems and/or building envelope into the structure. From 2006 through the end of 2013, each area of efficiency allowed the real estate client to deduct up to $0.60 per square foot in accelerated tax deductions. In a rehabilitation, the previous components replaced would have a retirement expense consideration per the unit-of-property determination.
It is also very important to remember that giving the real estate client a detailed fixed asset accounting of their real estate investment will also allow the retirement of the tangible personal property properly, thus eliminating recapture of such retired assets. This can be as big a tax benefit as all the other “next generation” benefits outlined.
One critical aspect of the new disposition rules is the fact that the look-back period expires in 2013. This is a key look-back deduction to clean up any real estate client’s fixed asset schedule for the components of their building. No CPA firm should wait too long to understand and utilize this feature of the regulations, as late adoption in this case would likely lead to some very unhappy clients.
Michael Daszkal, managing partner of the South Florida-based CPA firm DaszkalBolton, said, “The new tangible regulations have bolstered the way we approach cost segregation studies, and the benefits of these combined engineering services have made cost segregation our number one consulting service in terms of revenue and new client attraction.”
It’s easy to see why. When combined, all these additional “next generation” benefits clearly demonstrate why cost segregation is included on the list of top consulting services for the CPA. As Allan Koltin concluded, “The CPA firms that miss these client opportunities will hurt their reputation and growth.”
Heidi Henderson is vice president of marketing and business development at Engineered Tax Services. She previously worked as a staff accountant for over 15 years with companies in the real estate finance, development, construction and commercial property industries.