Cost segregation an important tax strategy for 2002.

Now is the time of the year when there is a plethora of articles providing tax strategy advice. For some ideas, the window has already closed. But, it is still open for cost segregation. 2002 was not a banner year with respect to providing tax legislation that provided substantial tax benefits for real property owners; however, cost segregation and "bonus" depreciation aspects of the act were an exception.

In fact AccountingToday, the business newspaper for tax and accounting community, has identified cost segregation as number one on its list of tax strategy opportunities.

Cost segregation is essentially a depreciation, tax deferral tool that provides for accelerated depreciation. For certain property types the net present value tax savings can be substantial. It is amazing how many clients initially think that cost segregation is a system to take advantage of a tax loophole. It isn't. Also, many clients think that it is only applicable to recent acquisitions or new properties. Cost segregation is retroactive to any property purchased since 1987.

One must remember that depreciation is the most important factor that can dramatically affect a project's after-tax cash flow.

In conducting a cost segregation study, the goal is to identify all (direct and indirect) costs of certain types of a property that can qualify for a faster write-off. The costs are then allocated to various "buckets" corresponding to reduced depreciation periods. Over the years, the federal government has adjusted not only depreciation recovery periods but also the convention (straight-line, 150% declining balance, 200% declining balance, etc.). If examined on a present value basis as a percentage of original cost, today's non-residential recovery period of 39 years is the highest since 1953. However, the IRS now permits the segregation of construction costs into shorter recovery periods. The resulting "blended" depreciation recovery period is a desirable, much larger depreciation deduction within the early years of the hold. And, the greater the tax rate of the taxpayer (owner), the greater the tax benefit.

To jump-start the economy, the Job Creation & Worker Assistance Act of 2002 allows you to claim a "bonus" depreciation of 30% on certain qualified leasehold improvements as long as the property was not placed in service within the last three years. Qualifying assets include such items carpeting and flooring, appliances, computer related wiring and support systems, etc. These days, employing cost segregation techniques could also be construed as doing your patriotic duty to help lift-up this economy that keeps muddling along.

The amount of savings depends on the building type, use, its depreciable basis, and the tax rate of the taxpayer, and the recovery period. Most owners depreciate their buildings over 39 years if it is non-residential or 27.5 years if it is residential real estate. Typically, the net present value savings can range from 2% to 5%. For a $5 million building that amounts to $100,000 to $250,000.

Certain buildings are better candidates than others. For instance, buildings with extensive site work improvements, process or manufacturing related systems, furnishings or appliances, etc. are all good candidates. This would include warehouses and distribution facilities, laboratory and biomedical research and development facilities, manufacturing facilities, multi-family buildings, offices, shopping centers, etc. Although tenant improvement work is generally depreciated over 39 years, most law offices have a preponderance of millwork, built-ins, specialty lighting, etc. which would qualify for a shorter recovery period.

Based on recent IRS Court Rulings, now all site related improvements such as paving, curbing, utilities, lighting, etc. can be depreciated over 15 years instead of 27.5 or 39 years. If we take the position that the taxpayer is in the highest income bracket and subject to New York State tax as well, for every $1 million of site related improvements that are re-classified, the taxpayer will save $100,000.

Using the same parameters and re-classifying $1 million from 27.5 years to a 7-year recovery period would provide $230,000 of present value tax benefits. Now, most residential appliances, kitchen cabinets, carpeting, millwork, signage, telecommunications systems, etc. can qualify for a 7- or 5-year recovery period.

Cost segregation studies apportion the costs (both direct and indirect) of specific components of the building a site to certain federal tax depreciable recovery periods. To optimize the reclassification from longer lives to shorter lives, an analysis of a property is required. This is accomplished by preparing a detailed cost estimate of pertinent components and systems, and reconciling such costs with the tax documents. Preparing a cost segregation study requires a skill and understanding of IRS and tax court case law complemented by engineering and cost estimating skills.

The IRS now permits the taxpayer to receive "catch-up" depreciation, a tax benefit "refund." This is the difference between the depreciation taken thus far and the depreciation that could have been taken once the depreciation was re-figured using cost segregation techniques. This "catch-up" depreciation can be taken within a single tax year. Up until March 2002, it had to be taken over a 4-year period. Depending on when the property was acquired, this single year tax benefit could be a windfall.

If you plan to own the asset for at least four years and it's acquisition cost was at least $1 million, inquire about cost segregation opportunities. Just about all cost segregation professionals will provide a complimentary estimate of the projected savings. Cost segregation is straightforward, it is not "risky" or audit triggering, follows IRS guidelines, and the money saved can be substantial. Why pay more in taxes than you have to?