A pleasant surprise from the Internal Revenue Service: new depreciation rules can turn your building into a big money saver. (Feature Article).

The Internal Revenue Service (IRS) recently began offering a nice surprise to long-term care (LTC) owners--a process, called "cost-segregation studies," that can actually reduce current-year taxes and immediately improve cash flow. Although this is available for any commercial building, LTC facilities enjoy some of the highest savings levels because of their specialized equipment. In recent projects, LTG tax savings ranged over an astounding 30 to 38% of original construction costs.

Recent tax law changes now allow building owners to depreciate certain assets in 5 years rather than the formerly allowed 15, 27.5 or 39 years. In March 2002, IRS Revenue Procedure 2002-19 added another perk: Owners of properties five years old or more can now take the full tax savings identified by a cost-segregation study in one year rather than spread it over the previously allowed four years.

Many owners initially yawn at these seemingly dry statements--but they perk up quickly when the financial lingo is translated to savings of $2.7 million (for 108 units), growing to $3.5 million and $10.1 million in progressively luxurious LTC facilities (Table). These savings immediately reduce current-year tax liability. Furthermore, any excess can be used as a "carry forward" for future years or a "carry back" for prior years. Some facilities may even receive tax refunds if depreciation creates excess tax paid by the facility that year or the previous five years. This process can increase cash on hand, freeing it for other operations, capital expenditures or additional acquisitions.

Owners should understand up front that this is a highly technical aspect of tax law, requiring professionals who specialize in it. Many CPAs are not familiar with the new rules but, on the other hand, they shouldn't feel responsible for knowing very technical tax law outside their normal practice areas. In other words, the cost-segregation process is ancillary to a facility's existing CPA relationships and should in no way interfere with them, although efforts must be coordinated.

Both owners and CPAs frequently confuse the new rules with the outdated "component depreciation" that was eliminated in the 1980s. Component depreciation related to real estate--the permanent building, including walls, floors and the like. Cost-segregation studies deal with personal property--nonpermanent assets within a building. The two are not, and never have been, the same.

So, how does it work?

New buildings, existing buildings, renovations and new acquisitions all qualify for "cost segregation." These studies are collaborative between LTC owners and the firm selected to perform the study. The analysis uses federal tax guidelines, court decisions and IRS private letter rulings covering more than 130 different asset categories, with 800 types of depreciable personal property, eight recovery periods and three depreciation methods.

In performing a study, a team of tax and real estate professionals should perform:

* Data collection, to include architectural/engineering drawings/specifications, contractor invoices, architectural fees, costs/invoices from vendors, and records of discussions with property representatives

* Inspection and exhaustive inventory of the property

* Identification of personal property and land improvements

* Documentation of cost allocation, including hard and soft costs

* Writing a final report to the owner and filing with the Washington, D.C. IRS office

More than 130 different asset categories fall into the three major areas listed below, each shown with specific examples of assets and related savings (including both materials and labor). Differences in savings are driven by facility size, level of luxury offered and, sometimes, geographic cost-of-labor factors:

1. Primary Power. This includes specialty electrical, mechanical, plumbing, lighting and related fixtures that add more to functionality of the equipment than to the building itself. As an example, a 172-unit facility found savings of $96,000 on a diesel generator, an asset many would easily identify. However, it also identified another $303,000 in special wires, fittings, tray cable and conduit--items frequently overlooked in depreciation. A 193-unit facility saved $11,800 by correctly identifying its laundry room lint collector as an eligible item, along with $4,536 in reinforced plastic pipe in the kitchen.

2. Permanency. The definition of this has vexed tax professionals for years, but the new rules are very specific: A permanent-appearing unit that can be easily disassembled and moved without damage may qualify for faster depreciation. Under farmer law, cabinets attached to the walls became "permanent" simply because they looked immovable. Today, they are recognized for faster depreciation because they truly are not a permanent part of the building (i.e., the walls would not fall down if they were removed).

The 193-unit facility also saved $22,900 by identifying its range hood fire-protection system as eligible, and the kitchen floor grating netted another $5,650. Neither is permanent to the building, despite appearances.

All LTC facilities have nurse-call systems, none of which are permanent. The 108-unit; facility saved $32,400 on the master control alone, while the 193-unit saved $70,125.

3. Decorativeness. Traditionally, this is another area of confusion. This category includes items designed and constructed solely to provide access for inspection, repair or operation of equipment, such as catwalks, as well as raised floors and insulated walls. It also includes items that happen to be attractive, but serve a useful purpose in the operation or durability of the property.

A prime example would be the sprinkler system. Most people can visualize the metal flange that protrudes from the ceiling--whether it is chrome, brass, etc.--which is a decorative attachment to the sprinkler head, offering protection to the sprinkler and visibility to pedestrians. Recessed units are also considered decorative. These can be reclassified and depreciated over five years.

Marble thresholds in patient doorways provide long-term durability, happen to be "decorative," and also qualify now for five-year depreciation. The 172-unit facility saved $17,900 on these thresholds.

Some assets straddle categories. For example, virtually all LTC facilities use corner guards that can meet both permanency and decorativeness tests. The 172-unit facility used 6,000 high-end, screw-mounted guards that ultimately netted it $76,200 in depreciation. The 193-unit facility used 4,000 guards, both screw-and adhesive-mounted, saving $23,700. The 108-unit facility used 1,500 adhesive-mounted guards, saving $8,500.

Two other frequently overlooked items are ID signs (found at nursing stations), room numbers in Braille and patient tackboards; they meet both permanency and decorativeness tests. ID signs range from $30 to 40 each, while tackboards range from $25 to 40 each. These small items add up to significant savings for an LTC facility.

Study Team Requirements

The IRS Chief Counsel Memorandum on cost segregation is very emphatic about the level of detail and documentation necessary for an acceptable study. Furthermore, it specifically requires a third-party (objective) evaluation.

The required professional certifications for those performing the studies are not made explicit. However, the complexity of both tax law and commercial property law makes it fairly impossible to achieve a study acceptable to the IRS without a solid team performing it. Such a team will offer a tax counsel and/or a CPA supported by commercial property experts (e.g., valuation, realty or construction specialists) and/or professional engineers specifically experienced in tax depreciation techniques.

The team could have a formalized structure within one firm, or could be retained on a subcontracted basis, with members from diverse companies who have worked together on these studies. A team should cover all disciplines, because no one can anticipate the unique conditions in any given building.

OverLooked Opportunities

Owners frequently lump site improvements into an overall 39-year building depreciation (itself a misclassification, as it should be 27.5 years). However, they miss significant savings, because most site improvements qualify for 5- or 15-year schedules. For example, a light pole is 5 years, but the base of that pole is 15 years--not 39 years or 27.5 years.

Further savings are missed in movable personal property, such as patient beds, night tables and guest chairs, which are, in fact, five-year properties but often misclassified as seven-year.

Conclusion

By reclassifying and accelerating depreciation, LTC owners can realize significant savings within one year on LTC personal property. In-depth analysis can locate misidentified assets for additional savings. A thorough cost-segregation study that appropriately identifies all reclassifications can offer savings in the range of 35 to 38% of original construction for many LTC owners, increasing cash flow and freeing finances for other purposes. This would include the purchase of additional facilities, which would then qualify for a cost-segregation study as newly acquired property.

It is always wise, of course, to keep precautions in mind. To date, IRS reviews/challenges of these studies seem to focus on those facilities that "push the envelope" in identifying personal property. For example, the main cooling towers bolted to the roof are an integral part of the building, not personal property. The IRS has challenged and successfully stopped this abuse.

As a new process, cost-segregation studies sometimes create questions among controllers and existing CPAs. As alluded to earlier, although efforts must be coordinated, this process is ancillary to those relationships and in no way interferes with them. This is well outside the practice area of most CPAs and controllers; accordingly, owners should not expect their CPAs to be experts in, or even familiar with, the new rules. CPAs are sometimes skeptical, or even feel that they have let their clients down. In reality, these professionals practice in a completely different tax specialty area. A cost-segregation study team should have experience and expertise in this specific field.

Table

Case Studies: LTC Tax Savings From Accelerated Depreciation Studies.

LTC Property    Materials, Labor,  Site Work  Professional  TOTAL
Description     & Allocated                   Fees          SAVINGS
                Overhead

Depreciation    5 year             15 year    To be
Classification                                allocated
                                              5 or 15 year

108-Room,       $2.12 million      $141,000   $466,000      $2.7
Average Fit-Up                                              million

193-Room,       $2.75 million      $66,000    $683,000      $3.5
Above Average                                               million
Fit-Up

172-Room,       $8 million         $1.3       $800,000      $10.1
Luxury Fit-Up                      million                  million

James I.. McDonald, JD, CPA, LLM, is a tax attorney/CPA with Tax Recovery Specialists, LLC, and McDonald/Doran, PC, in Atlanta, Georgia. His 29 years of experience includes practice with the IRS. For further information, call [phone]. To comment on this article, please send e-mail to [e-mail].