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COST SEGREGATION

Cost Segregation and Real Estate Investment Returns Segregating costs can significantly increase the rate of return.

Author: DOUGLAS S. BIBLE AND STANLEY HAYS. DOUGLAS S. BIBLE is Cloyd Professor of Real Estate in the College of Business Administration at Louisiana State University Shreveport. STANLEY HAYS, CPA, is an assistant professor of accounting there.

Recently, an abundance of information, predominantly from accounting firms, has been presented regarding the tax benefits of cost segregation and tax planning. A typical Web search of the phrase “cost segregation” quickly reveals thousands of accounting/financial firms that reference this topic. The interest in this area was spurred by Hospital Corporation of America (HCA), 1 in which the Tax Court permitted HCA to use cost segregation for a “multitude” of improvements. While much of the attention has focused on the present value of the tax savings, applied examples of the after-tax effects on rate of return and net present value for real estate investment projects, including the tax consequences of the sale of the property, have not been widely reported. The effects of using cost segregation techniques on a proposed new apartment complex development are examined below, with an emphasis on the internal rate of return (IRR) and net present value (NPV) comparisons for a particular project for a seven-year holding period.

Background Based on the different lives assigned by the Modified Accelerated Cost Recovery System (MACRS), and the different treatments for depreciation recapture specified by Section 1245 (depreciation of tangible personal property) and Section 1250 (depreciation of real property), it is evident that Congress intended to distinguish between real property and tangible personal property, effectively allowing the use of cost segregation. In recent years, taxpayers have been increasingly using cost segregation techniques to their advantage, but the IRS requires accurate cost segregation studies to document the depreciation that may be allowed. The current MACRS system allows for most personal property to be depreciated over three-, five-, or seven-year recovery periods using the double declining balance method, while land improvements such as sidewalks, fences, and docks are depreciated over 15 years using the 150% declining balance method. 2 While the building may be subject to the 39-year (for commercial property) or 27.5-year (for residential property) depreciation schedule, valuing and depreciating personal property and land improvements separately provides a financial advantage because the shorter depreciation periods allow earlier deductions, resulting in earlier positive cash flows from income tax savings. Reg. 1.48-1 is helpful in determining which components are structural and thus not eligible for personal property classification. This regulation refers to property that “relates to the operation or maintenance of a building” and may include walls, floors, and ceilings, and permanent covers such


as windows and doors, as well as central air conditioning, electrical wiring, plumbing and fixtures, and sprinkler systems. These items are generally considered structural, and must be depreciated over 27.5 or 39 years, while the non-structural components may be eligible for the five- or sevenyear depreciation schedules. Other guidelines that help to identify tangible personal property include answering questions such as whether the property can be moved, how difficult it would be to remove it, whether it is designed to remain permanently in place, and whether there are circumstances that tend to show the intended length of affixation. 3 The Cost Segregation Audit Techniques Guide, 4 produced by the IRS in 2004 provides an excellent review of the background and current use of the cost segregation procedures and is an important source of information found in the following paragraphs. It is important to note that the IRS states that the Guide is not an IRS pronouncement and may not be cited as authority. In recent years, an increasing number of taxpayers have taken advantage of shorter recovery periods and rapid depreciation by examining the individual components of the various assets and property owned. To identify the value and depreciation classification for the various property components, such as land improvements, equipment, furniture, and fixtures, specialized cost segregation studies must be performed. These professional studies, often completed by engineering or architectural firms in conjunction with accounting firms, provide a reliable basis for the taxpayer to allocate the cost of buildings (acquired or built) between Section 1250 property (real property depreciated over 39 or 27.5 years) and Section 1245 property (tangible personal property depreciated over five or seven years). In addition, the study would indicate the amount of land improvements (such as sidewalks, drainage facilities, and parking lots) that could be depreciated over 15 years. Such studies are expensive, however, and the cost must be taken into consideration in analyzing the benefits of cost segregation. Such a study could reveal, for example, that items such as computer systems, phone systems, carpeting, and wall coverings may be reported as Section 1245 property with shorter recovery periods. It is also possible that a portion of the building components may be treated as Section 1245 property. “For example, a study may conclude that 15 percent of a building's electrical system directly supports section 1245 property, such as specialized kitchen equipment. Based on that conclusion, the study would then treat 15 percent of the electrical system as section 1245 property.� 5 In the HCA decision, the Tax Court ruled that such tangible personal property included as a part of the building acquisition cost could be treated separately for deprecation purposes. It appears that the HCA case has opened the floodgates for such studies to be performed by engineers and architects, and encouraged by accounting firms. Since the IRS has provided no specific standards for cost segregation studies, they vary widely with no standard methodology applied. The IRS Guide notes that this lack of consistency and the complexity of the law often require IRS examiners to request assistance from specialists such as engineers, computer audit specialists, and technical advisors.

Depreciation and the IRS Depreciation is an allowance for the physical deterioration of property used in a trade or business. Methods used in the past included straight line, declining balance, and sum of the year's digits. Adjusted basis (cost minus depreciation allowed) was treated as return of capital upon the sale of the property. A shorter useful life was considered desirable since it produced a reduced tax liability in early years resulting in additional net cash flows. Prior to the 1981 enactment of the Accelerated Cost Recovery System (ACRS), composite depreciation ranging from 1.5% per year to 3.5% per year was applied, or the component method under which building equipment was depreciated over a range from five to 25 years and buildings from 50 to 75 years was used. 6 In 1959, the Tax Court allowed a component method for


deprecation, under which a building shell had a useful life of 40 years; the plumbing, wiring, and elevators had useful lives of 15 years; and the paving, roof, and heat and air had useful lives of ten years. 7 For assets placed in service after 1970, an elective Asset Depreciation Range (ADR) system was developed. The ADR system placed all tangible assets in one of about 100 asset guideline classes based on the business and industry of the taxpayer. The IRS also noted that the taxpayer could use component deprecation if a qualified appraiser alocated costs between non-depreciable land and depreciable building components. The ACRS was a mandatory system providing five recovery periods. in addition real property was reduced to either a 15-, 18-, or 19-year recovery period. The ACRS was effective for years beginning in 1981. Enacted in 1986, the MACRS made important changes that increased the recovery periods for nonresidential real property to 31.5 years (later increased to 39 years) and 27.5 years for residential rental property. Equipment and machinery was given a three-, five-, or seven-year recovery period, while improvements to land were assigned a 15-year recovery period. The investment tax credit (ITC), referred to in the HCA case, was enacted in 1962 and was designed to encourage “the modernization and expansion of productive facilities through the purchase of certain new or used assets for use in a trade or business.” 8 The credit started out at 7% and later increased to 10%. Many changes were made in the ITC over the years until it was repealed in the Tax Reform Act of 1986, in part because of the burden placed on smaller taxpayers to pay for expensive ITC studies. Current cost segregation procedures rely heavily on guidelines developed for the application of the former ITC provisions. The lack of bright-line tests for distinguishing between Section 1245 and Section 1250 property is clearly a source of concern and perhaps confusion. The taxpayer and his or her professional advisors should be aware of the IRS field guidance as noted in 1999 advice from the IRS Chief Counsel. 9 The IRS makes the following recommendations for field agents examining cost segregation studies:

    

The determination of whether an asset is a structural component or tangible personal property is a facts-and-circumstance assessment. The use of cost segregation studies must be specifically applied by the taxpayer. Allocations must be based on logical objective measures of the portion of equipment that constitutes Section 1245 property. An accurate cost segregation study may not be based on contemporaneous records, reconstructed data, or taxpayer's estimates or assumptions that have supporting records. Cost segregation studies should be closely scrutinized by the field agent. 10

Expense or capitalize While the MACRS assigns five- or seven-year lives to most tangible personal property, and 15 years to land improvements, there is an additional elective provision that could possibly accelerate the deductions even more. Section 179 has historically allowed eligible taxpayers to elect to expense rather than capitalize up to $25,000 of tangible personal property placed in service in a given tax year. Use of this election may magnify the benefits of the time value of money by allowing deductions in the year of acquisition rather than spreading the effects over several years. Expensing could be limited in two ways, however. 11 First, for a taxpayer who places more than $200,000 of eligible tangible property in service during a given year, the maximum expensing is


reduced dollar-for-dollar for all additions above $200,000. As a result of this phase-out, the expensing election may be available for only relatively small investments. The second limitation is the net taxable income of the taxpayer. Where ownership of the qualified property is in a pass-through entity, the potential limitations are examined at the individual taxpayer level. The Jobs and Growth Tax Relief Act of 2003 raised the $25,000 limitation to $100,000 and the $200,000 phase-out level to $400,000 for 2003, 2004, and 2005. These limitations are indexed; for example, the maximum investment level for 2004 is $402,000. The American Jobs Creation Act of 2004 extended the increased level of optional expensing through 2007. For years beginning after 2007, the limitations revert back to $25,000 and $200,000 respectively, without indexing.

Personal property assets for apartment projects One accounting/consultant firm provided a list of assets that typically are considered for personal property treatment for apartments. 12 Assets include kitchen cabinets and countertops, ranges and stoves, exhaust fans, refrigerators, microwave ovens, dishwashers, garbage disposals, sinks, washer dryer hookups, telephone and cable TV wiring, smoke detectors, window treatments, carpet, vinyl tile, closet shelving and furniture, and, in the laundry room, washers and dryers. Land improvements such as paving, curbing and sidewalks, fences and retaining walls, underground storm drains, domestic water and fire water hookups, as well as gas piping and underground cable, electrical and telephone, site lighting, and pools should be considered for inclusion. The same goes for recreational facilities and landscaping. Prior to the enactment of the ACRS, component versus composite depreciation enhanced the valuation of real estate investments through tax savings in the early years resulting from the shorter lives of the components compared to the life of the building. Component depreciation resulted in significantly higher appraised values resulting from the increased cash flows in these early years. The discussion below examines cost segregation techniques in the 2000s, similar to the 1970s component depreciation, using an after-tax NPV approach similar to that taken in a recent article dealing with state tax credits and rates of return. 13 The NPV approach finds the present value of all the after-tax cash flows (based on the investor's required rate of return). If the NPV is positive the investment is acceptable because the rate of return exceeds the investor's requirements, but if the NPV is negative the investment should be rejected. Classification of a significant portion of the total cost of real estate as something other than real property is beneficial because the shorter lives assigned to tangible personal property and land improvements allow the taxpayer to recognize more depreciation in earlier years. In addition, expensing some of the costs may also provide earlier tax savings. Realizing the tax savings from these accelerated deductions and expensing options helps maximize the value of the tax savings, and generally increases after tax-rates of return.

Proposed new apartment construction To study the tax effects of the cost segregation technique, consider an example of a proposed apartment complex located in the southern United States. The project is an apartment community of over 200 units. The first phase of the project, evaluated in this analysis, allows for the construction of 216 apartment units with 223,120 square feet of rentable space on 12.7 acres of land. The land costs for the first phase are $1,374,624. (A second phase, consisting of an additional 180 units on 10.2 acres of land, is planned following successful rent up of the first phase.)

Details on costs.


Land costs are $1,374,624, while the total improvement costs are $13,686,104 (Exhibit 1, page 40), producing an overall project cost of $15,060,528. Total improvement costs include transactions costs, legal fees, carrying costs, overhead and profits, and other acquisition costs. As shown in Exhibit 2, page 41, land improvements are estimated at $1,218,107, including site work, parking and paving, and site utilities. These improvements are assigned to the MACRS 15-yearlife category in the cost segregation approach. Personal property assets include such items mentioned earlier as kitchen cabinets, countertops, ranges, refrigerators, dishwashers, and sinks for the individual units or clubhouse. Combining these with the window treatments, carpet, tile, closet shelving, furniture and hook-ups for cable, telephones, and washers and dryers in the units, as well as washer and dryers in the laundry room, results in a total cost of $2,203,418 that may be depreciated over seven years (Exhibit 2).

Exhibit 1.Apartment Building (See page 46). Number of units 24 48 36 40 56 12 50 54

1 bedroom 2 bedroom 3 bedroom garages carports

Monthly rent $615 $640 $725 $750 $800 $905 $ 75 $ 15

Monthly Gross Rent (residential) Concessions/premiums, other fees

Monthly rent by unit type $14,760 $30,720 $26,100 $30,000 $44,800 $10,860 $ 3,750 $ 810 $ 6,896

Potential Gross Income

Annual total rent $ 177,120 $ 368,640 $ 313,200 $ 360,000 $ 537,600 $ 130,320 $ 45,000 $ 9,720 --------$1,941,600 $ 82,752 ---------$2,024,352

Exhibit 2.Depreciation and Ownership (See page 46).

Composite* Component** 15 year 7 year 27.5 year Total

Composite* Component** 15 year 7 year 27.5 year Total

Basis ----$13,686,104

Year 1 -----$476,961

Year 2 -----$497,627

Year 3 -----$497,627

Year 4 -----$497,627

$ 1,218,107 $ 2,203,418 $10,264,579 $13,686,104

$ 60,905 $314,868 $357,721 $733,494

$115,720 $539,617 $373,220 $1,028,557

$104,148 $385,378 $373,220 $862,746

$93,794 $275,207 $373,220 $742,221

Basis ----$13,686,104

Year 5 -----$497,627

Year 6 -----$497,627

Year 7 -----$497,627

Total ----$3,462,721

$ 1,218,107 $ 2,203,418 $10,264,579 $13,686,104

$ 84,415 $196,765 $373,220 $654,400

$ 75,888 $196,545 $373,220 $645,653

$ 71,868 $196,765 $373,220 $641,854

$ 606,739 $2,105,146 $2,597,041 $5,308,926

LLC (10 investors) Fed Tax bracket Total cost Less mortgage

10 35.00% $15,060,727 13,554,655


----------$ 1,506,072

Total equity Total equity per partner

$

150,607

* Straight-line method, 27.5 years. ** Determined by cost-segregation study. The rental projections, along with the size and mixture of apartment units, are shown in Exhibit 3, page 41. The projected monthly rent of $157,239 averages $.70 per square foot or $728 per month per unit. Gross annual income is $2,024,352 with a vacancy rate at 7%. The gross rent includes apartments plus rent for 50 garages and 54 carports. The apartment mix is estimated at 33% one-bedroom, 62% two-bedroom and 6% three-bedroom units. Rents are $640 and $615 for the one-bedroom units, $725, $760, or $800 for two bedrooms, and $905 for three-bedroom units. Operating expenses of $3.13 per unit per month result in $715,225 in annual expenses. Net operating income (after expenses) is $1,166,432 per year (Exhibit 3).

Exhibit 3.Before-Tax Cash Flows (See page 47). Operating expenses of $3.21 sq ft per month: $716,215 Vacancy & Collection : 7.00% Year 1 -----$2,024,352 141,705 1,882,647 716,215 1,166,432 881,386 $ 285,046

Gross Income Less vacancy & collection Effective Gross Income Less operating expenses Net Operating Income Less mortgage payment Before tax cash flow

Gross Income Less vacancy & collection Effective Gross Income Less operating expenses Net Operating Income Less mortgage payment Before tax cash flow

Year 2 -----$2,024,352 141,705 1,882,647 716,215 1,166,432 881,386 $ 285,046

Year 5 -----$2,024,352 141,705 1,882,647 716,215 1,166,432 881,386 $ 285,046

Year 3 -----$2,024,352 141,705 1,882,647 716,215 1,166,432 881,386 $ 285,046

Year 6 -----$2,024,352 141,705 1,882,647 716,215 1,166,432 881,386 $ 285,046

Year 4 -----$2,024,352 141,705 1,882,647 716,215 1,166,432 881,386 $ 285,046

Year 7 -----$2,024,352 141,705 1,882,647 716,215 1,166,432 881,386 $ 285,046

The projected amount of the mortgage loan is $13,554,655, based on 90% of the total cost. It will have an interest rate of 5.88% annually, or 0.49% monthly. The loan amount ($62,753 per unit) results in monthly payments of $73,449 ($881,386 annually), based on obtaining a 40-year HUD loan (Exhibit 4, page 42). Deducted from the total project cost, this leaves total equity of $1,506,067, to be split among the ten LLC investors. Adding the $30,000 cost of the cost segregation study leaves the ten investors bearing overall costs of $1,536,072.

Exhibit 4.Mortgage (See page 47).

End of year balance

Year 0 -----$13,554,655

Year 1 -----$13,467,971

Year 2 ------$13,376,051

Year 3 -----$13,278,578


Monthly Pmt Annual Principal Annual Interest (Total Pmt-Principal) Annual Pmt

End of year balance Monthly Pmt Annual Principal Annual Interest (Total Pmt-Principal) Annual Pmt

$

73,449

$ $

73,449 86,684

$ $

73,449 91,920

$ $

73,449 97,473

$ $

794,702 881,386

$ $

789,466 881,386

$ $

783,913 881,386

Year 4 -----$13,175,216 $ 73,449 $ 103,362

Year 5 -----$13,065,610 $ 73,449 $ 109,606

Year 6 -----$12,949,383 $ 73,449 $ 116,227

Year 7 -----$12,826,134 $ 73,449 $ 123,249

$ $

$ $

$ $

$ $

778,024 881,386

771,780 881,386

765,159 881,386

758,137 881,386

The proposed ownership is for a limited liability company with ten investor/owners, all assumed to be in the 35% tax bracket (the highest individual tax bracket through 2010) and subject to the passive activity loss limitation. Analysis of the after-tax cash flows for this project are examined for two scenarios: (1) all improvements are all depreciated over the required for 27.5 years, and (2) the site improvements are depreciated over 15 years and the personal property assets are depreciated over seven years.

Cash flow analysis of the rehabilitation project The projected annual cash flows of $285,046 generated from this project are shown in Exhibit 3. The assumptions are based on projected stable market conditions. Operating expenses are assumed to remain constant over the seven years

After-tax cash flows. The after-tax cash flows from operations for each investor are shown in Exhibit 5, page 42, for the composite depreciation method and in Exhibit 8, page 44, for the cost segregation application. The initial analysis indicates that the project provides tax savings due to losses (following the deduction of interest and depreciation). For this analysis, it is assumed that the investors have adjusted gross income in excess of $250,000 and enough passive activity income to offset the negative taxable income.

After-tax cash flow from the sale. It is assumed that the property is to be sold at the end of the seventh year, with a 2% annual appreciation rate (Exhibit 6, page 43, and Exhibit 9, page 45). The investment returns as shown in Exhibit 7, page 43, and Exhibit 10, page 46, indicate a net present value of $88,718 and an internal rate of return of 28.04% with the composite depreciation method, and net present value of $107,561 and internal rate of return of 32.07% with the cost segregation depreciation method. The net present value and rate of return for the cost segregation method includes an additional $30,000 of initial equity for the project (increasing each investor's equity from $150,607 to $153,607) to account for the projected additional cost of completing the cost segregation study. Thus it is clearly evident that the cost segregation depreciation method results in a significant increase in the rate of return and corresponding net present value of the project.

Exhibit 5.After-Tax Cash Flow from Operations, Composite Depreciation Method* (See page 47).


Year 1 -----Net Operating Income $1,166,432 Less deprecation $ 476,961 Less mortgage interest $ 794,702 Federal taxable income -$ 105,231 Per investor in LLC (10 investors) Before-Tax Cash Flow $ 28,505 Less federal taxes taxable income** -$ 10,523 tax savings from loss***-$ 3,683 After-Tax Cash Flow $ 32,188

Year 2 -----$1,166,432 $ 497,627 $ 789,466 -$ 120,660

Year 3 -----$1,166,432 $ 497,627 $ 783,913 -$ 115,107

Year 4 -----$1,166,432 $ 497,627 $ 778,024 -$ 109,219

$

28,505

$

28,505

$

28,505

-$ -$ $

12,066 4,223 32,728

-$ -$ $

11,511 4,029 32,533

-$ -$ $

10,922 3,823 32,327

Year 5 -----Net Operating Income $1,166,432 Less deprecation $ 497,627 Less mortgage interest $ 771,780 Federal taxable income -$ 102,974 Per investor in LLC (10 investors) Before-Tax Cash Flow $ 28,505 Less federal taxes taxable income** -$ 10,297 tax savings from loss*** -$ 3,604 After-Tax Cash Flow $ 32,109

Year 6 -----$1,166,432 $ 497,627 $ 765,159 -$ 96,353

Year 7 -----$1,166,432 $ 497,627 $ 758,137 -$ 89,332

$

28,505

$

28,505

-$ -$ $

9,635 3,372 31,877

-$ -$ $

8,933 3,127 31,631

* Assumes sufficient passive income available to offset passive loss each year. ** Passive loss. *** Assumed 35%.

Exhibit 6.After Tax Cash Flow from Sale of Property at end of Year 7, Composite Depreciation Method (See page 47). Sale Price Less mortgage balance Before-tax cash flow (BTCF) Sale Price Less adjusted basis total gain

$17,300,042 -$12,949,383 $ 4,350,659 $17,300,042 $11,598,007 $ 5,702,035

Taxes Tax on gain from appreciation (15%) on gain from unrecaptured depreciation (25%) Total BCTF sale per investor Less taxes ATCF per investor

$ $ $

Total $2,239,314

Per owner $223,931

$3,462,721 $5,702,036

$346,272 $570,204

Tax per owner $ 33,590 $ 86,568 $120,158

435,066 120,158 314,908

Exhibit 7.Rate of Return Analysis, Composite Depreciation Method (See page 47).


After tax cash flows Operations Sale Operations & Sale After tax cash flows Operations Sale Operations & Sale

Year 0 ------$150,607 -$150,607 Year 4 -----$32,327 $32,237

Required rate of return Net present value IRR

Year 1 -----$32,188 $32,188 Year 5 -----$32,109 $32,109

Year 2 -----$32,728

Year 3 -----$32,533

$32,728

$32,533

Year 6 -----$31,877

Year 7 ------$ 31,631 $314,908 $346,539

$31,877

15% $88,718 28.04%

Exhibit 8.After Tax Cash Flow from Operations, Cost Segregation Method* (See page 47). Year 1 Year 2 Year 3 Year 4 --------------------Net Operating Income $1,166,432 $1,166,432 $1,166,432 $1,166,432 Less depreciation $ 733,494 $1,028,557 $ 862,746 $ 742,221 Less mortgage interest $ 794,702 $ 789,466 $ 783,913 $ 778,024 Federal taxable income -$ 361,764 -$ 651,591 -$ 480,226 -$ 353,813 Per investor in LLC (10 investors) Before Tax Cash Flow $ 28,505 $ 28,505 $ 28,505 $ 28,505 Less federal taxes taxable income (passive loss)-$ 36,176 -$ 65,159 -$ 48,023 -$ 35,381 tax savings from loss (35%) -$ 12,662 -$ 22,806 -$ 16,808 -$ 12,383 Cash flow after taxes $ 41,166 $ 51,310 $ 45,313 $ 40,888 Year 5 -----$1,166,432 $ 654,400 $ 771,780 -$ 259,748

Net Operating Income Less depreciation Less mortgage interest Federal taxable income Per investor in LLC (10 investors) Before Tax Cash Flow $ Less federal taxes taxable income (passive loss -$ tax savings from loss (35%) -$ Cash flow after taxes $

Year 6 -----$1,166,432 $ 645,653 $ 765,159 -$ 244,379

Year 7 -----$1,166,432 $ 641,854 $ 758,137 -$ 233,559

28,505

$

28,505

$

28,505

25,975 9,091 37,596

-$ -$ $

24,438 8,553 37,058

-$ -$ $

23,356 8,175 36,679

* Assumes sufficient passive income available to offset passive loss each year.

Exhibit 9.After Tax Cash Flow from Sale, Cost Segregation Method (See page 47). Sale Price Less mortgage balance Before-tax cash flow

$17,300,042 -$12,949,383 $ 4,350,660


Sale price Less adjusted basis Total gain

$17,300,042 $ 9,751,802 $ 7,548,240

Taxes per partner on gain from appreciation (15%) on gain from unrecaptured depreciation (25%) Total BTCF sale per investor Less taxes ATCF per investor

$ $ $

Total

Per owner

Tax per owner

$2,239,314

$223,931

$ 33,590

$5,308,926 $7,548,240

$530,893 $754,824

$132,723 $166,313

435,066 166,313 268,753

Exhibit 10.Rate of Return Analysis, Cost Segregation Method (See page 47). After tax cash flows Operations Sale Operations & Sale

Year 0 ------$153,607 -$153,607

After tax cash flows Operations Sale Operations & Sale Required rate of return Net present value IRR

Year 5 -----$37,596 $37,596

Year 1 -----$41,166 $41,166 Year 6 -----$37,058 $37,058

Year 2 -----$51,310 $51,310

Year 3 -----$45,313 $45,313

Year 4 -----$40,888 $40,888

Year 7 -----$ 36,679 $268,753 $305,432

15% $107,561 32.07%

Conclusion The Code has variously tightened and liberalized the circumstances under which taxpayers may allocate a portion of the acquisition costs of buildings (whether purchased or built) to shorter life categories such as personal property and land improvements. Using this approach, taxpayers may take more deprecation deductions in the early years of a project at the expense of lower deductions in the later years of the long-lived assets. The presumed benefit of this strategy is an increase in net cash flows in the early years by reducing the negative cash flows of income taxes. With individual income tax brackets as high as 35%, these savings can be substantial. These depreciation differences are only timing differences, since the savings will have to be “paid back� to the federal government in the form of additional tax liabilities in the later years when the depreciation is lower. However, taking advantage of the depreciation recapture rules of Section 1250 and special capital gains rate for unrecaptured depreciation on real estate, taxpayers pay back the taxes saved in the earlier years by taking advantage of the more favorable capital gains rate, rather than the ordinary rate of 35% effective at the time the accelerated deductions are taken. Whether or not cost segregation is used, the economic gain (excess of sales price over original cost) is taxed at only 15%.


In the example presented above, the effect of the cost segregation approach results in a four percentage-point increase in the internal rate of return and an increase in net present value of $18,843 for the life of the project compared to composite depreciation. The difference in returns results from both the time value of money effect of accelerating deductions as well as converting tax savings at ordinary rates into tax costs at the more attractive capital gains rates on the sale of real estate. It is interesting to note that the portion of the acquisition price allocated to personal property may qualify for an additional benefit from the first-year expensing election. This elective benefit is limited, however, if total personal property additions in a given year exceed threshold amounts. It is also limited to the taxable income of the entity. These limitations are applied at the partnership level first. Since real estate rental projects usually do not generate net taxable income in the first several years, this potential increased advantage probably is not available for real estate investments owned in a pass-through entity. This discussion focused on residential rental property with a 27.5 year life. Possibly even greater advantages would be derived by converting a portion of the cost of non-residential 39-year property to the shorter seven- or 15-year categories.

1

109 TC 21 (1997). 2

Rev. Proc. 87-56, 1987-2 CB 674. 3

See Soled and Falk, "Cost Segregation Applied," 198 Journal of Accountancy 28 (August 2004), for a summary of several significant court cases that provide guidance for distinguishing between structural components and personal property. 4

IRS, Cost Segregation Audit Techniques Guide, 12/16/04, available at http://www.irs.gov/businesses/article/0,,id=134180,00.html (Chapter 1). 5

Id. (Chapter 2, "Bulletin F"). 6

Supra, note 4 (Chapter 2, "Bulletin F"). 7

Shainberg, 33 TC 24 (1959). 8

Supra, note 4 (Chapter 2, "Investment Tax Credit"). 9

CCA 199921045, 5/28/99. 10

Supra, note 4 (Chapter 2, "Chief Counsel Guidance"). 11

Section 179(b).


12

Cost Recovery Solutions, www.crscostseg.com. 13

Bible, Hays, and Parker, “Louisiana Tax Credit Adds Value to the Incentives for Rehabilitation of Historic Structures,” 14 J. Multistate Tax'n and Incentives 6 (June 2004). Document Title: Cost Segregation and Real Estate Investment Returns, Journal of Real Estate Taxation (WG&L) Checkpoint Source: Real Estate Taxation Preview © Copyright 2005 RIA. All rights reserved.


Cost Segregation Investment Returns