Increased cashflow for real estate owners.

In the last two years, several tax changes have provided real property owners with a great opportunity to use their assets to provide additional cashflow and increased internal rates of return (IRRs); however, 2004 is the last year to take full advantage of some of these savings.

Background

Over the past five years, knowledgeable tax professionals have been fine-tuning cost-segregation studies to save significant tax dollars for clients that own or lease real estate. Using a properly constructed and documented study, assets previously classified as 27.5- or 39-year property may be appropriately reclassified as five-, seven- or 15-year property. Accelerating depreciation produces tax savings and significantly enhances cashflow.

For example, items ranging from removable carpeting and strippable vinyl wall coverings, to soft costs (e.g., architects' fees and construction general conditions), to electrical, plumbing and mechanical work associated with personal property, are typically included in the 27.5- or 39-year pool. Using the engineering and invoice approach, a capital cost-segregation study can provide the documentation needed to segregate these costs according to their shorter useful lives, which increases the depreciation deduction's net present value, as well as cashflow resulting from tax savings in the asset's initial year.

Using Bonus Depreciation

By combining the 30% bonus depreciation enacted by the Job Creation and Worker Assistance Act of 2002 (increased to 50% by the Jobs and Growth Tax Relief Reconciliation Act of 2003) with a cost-segregation study, "qualified" new property eligible for 50% bonus depreciation with a modified accelerated cost recovery system (MACRS) five-year life, using a half-year convention, could qualify for as much as 60% of cost being depreciated in the first year. Obviously, the more personal property identified, the greater the tax savings. Recent cost-segregation studies have resulted in an average 3.27% increase to the IRR.

Sec. 168(k)(2)(A) defines "qualified property" as MACRS property with a class life of less than 20 years, water utility property, computer software that is not a Sec. 197 intangible and qualified leasehold improvement property. This is exactly the type of property identified through a cost-segregation study.

To take advantage of 50% bonus depreciation, property must have been acquired after May 5, 2003 and before 2005. Property acquired between Sept. 11, 2001 and May 5, 2003 will qualify for 30% bonus depreciation. In both cases, the property must be placed in service before 2005.

Look-Back Studies

Cost-segregation studies Call also benefit assets already placed in service.

Example: A $300,000 asset being depreciated over 27.5 years is reclassified as five-year property; the catch-up depreciation is computed as follows:

$248,880 depreciation for five-year property
  43,179 depreciation for 27.5-year property
$205,701

In the above example, there may be questions as to whether this is an accounting-method change resulting in a Sec. 481 adjustment. The issue was resolved in December 2003, when Treasury issued proposed, temporary and final regulations to clarify which depreciation changes are accounting-method changes; see Kane, Tax Clinic, "Change in Depreciation Method is Accounting-Method Change," p. 194, this issue.

Temp. Regs. Sec. 1.446-1T(e) (2)(iii), Example (9), addresses the general rule for accounting methods and concludes that the additional depreciation resulting from cost-segregation studies is clearly an accounting-method change to which a Sec. 481 adjustment applies. Thus, the additional depreciation can be taken in the year the study is effective, not at the time of disposition.

Conclusion

These regulations are good news for those contemplating cost-segregation studies and appear to show a pro-taxpayer intent. Past experience has shown that when a cost-segregation study is performed with a qualified team using the engineering and invoice approach, the IRS very rarely challenges any of the reclassifications.

FROM MARIANNE HEARD, MST, CPA, QUINCY, MA