When cost segregation costs extra.EXECUTIVE SUMMARY * Cost segregation segregation: see apartheid; integration. is a tax planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. technique that accelerates depreciation deductions for real property by reclassifying elements of a building as tangible personal property eligible for MACRS See Modified Accelerated Cost Recovery System. MACRS See Modified Accelerated Cost Recovery System (MACRS). depreciation. The technique may be advantageous when the discounted value of the tax savings exceeds the costs of its implementation. * One potential pitfall pit·fall n. 1. An unapparent source of trouble or danger; a hidden hazard: "potential pitfalls stemming from their optimistic inflation assumptions" New York Times. of cost segregation is its impact on a later exchange of the building for like-kind property Like-Kind Property Investment or business land/properties that are considered to be the same type and exchanging them is therefore tax-free. Notes: For example, you can exchange a car for another car tax-free, but not a car for a piece of land. . Generally, a taxpayer recognizes no gain or loss in a like-kind exchange of real estate. The creation of multiple asset classes makes it likely that gain will be recognized in an exchange that otherwise would be nontaxable, which may largely offset the initial benefits of cost segregation. * When a client is contemplating cost segregation, the tax adviser should discuss with the client the potential for an exchange of the property and incorporate an exchange in the analysis when appropriate. Failure to do so can lead to an unexpected and unfortunate tax and cashflow result. What a taxpayer gains in accelerated depreciation Accelerated Depreciation Any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset. Notes: The straight-line depreciation method spreads the cost evenly over the life of an asset. may be more than lost in a like-kind exchange. ********** [ILLUSTRATION OMITTED] Cost segregation is a popular tax planning technique for owners of depreciable depreciable Of, relating to, or being a long-term tangible asset that is subject to depreciation. real property. While it is a legitimate and sometimes beneficial technique, some taxpayers have adopted it without considering the potential adverse consequences that can occur upon disposition of the property. In particular, taxpayers and their advisers should be aware that cost segregation can result in later recognition of gain in a like-kind exchange of the property when gain otherwise would not have been recognized. Cost segregation, also called componentization, reduces tax by accelerating depreciation on components of a building. Depreciation is accelerated by reclassifying components as 5-, 7-, or 15-year modified accelerated cost recovery system Modified Accelerated Cost Recovery System (MACRS) A 1986 act that set out rules for the depreciation of qualifying assets, allowing for greater acceleration over longer periods of time. (MACRS) property rather than 39-year straight-line real property. This technique was revitalized re·vi·tal·ize tr.v. re·vi·tal·ized, re·vi·tal·iz·ing, re·vi·tal·iz·es To impart new life or vigor to: plans to revitalize inner-city neighborhoods; tried to revitalize a flagging economy. in the case Hospital Corporation of America The Hospital Corporation of America (HCA) is the largest private operator of health care facilities in the world. It is based in Nashville, Tennessee, United States and is widely considered to be the single largest factor in making that city a hotspot for healthcare , (1) in which the court allowed the taxpayer to categorize cat·e·go·rize tr.v. cat·e·go·rized, cat·e·go·riz·ing, cat·e·go·riz·es To put into a category or categories; classify. cat assets in a hospital into many classes depending on their separate lives based on whether the assets could be removed from the building and a number of other factors (discussed below). Assets such as lighting systems, movable walls, and ceiling grids were determined to be separable sep·a·ra·ble adj. Possible to separate: separable sheets of paper. sep from the real property or supporting a separable activity and thus eligible for accelerated depreciation. Examples of 15-year property include outdoor lighting, signage, and landscaping. Typical 7-year assets include floor and window coverings, decorative millwork, and electrical fixtures. Some assets identified in a componentization study may qualify for Sec. 179 expensing and/ or bonus depreciation, which could further accelerate depreciation. These assets are not generally those that would be treated as personal property in a like-kind exchange as would appliances and other freestanding free·stand·ing adj. Standing or operating independently of anything else: a freestanding bell tower; a freestanding maternity clinic. equipment. (2) Like-kind exchanges under Sec. 1031 allow a taxpayer to defer de·fer 1 v. de·ferred, de·fer·ring, de·fers v.tr. 1. To put off; postpone. 2. To postpone the induction of (one eligible for the military draft). v.intr. recognition of realized gains Realized Gain A gain resulting from selling an asset at a price higher than the original purchase price. Notes: There may be tax consequences for a realized profit. when exchanging property for like-kind property. Because of the broad definition of "like-kind" real estate, this technique is especially valuable to owners of commercial and residential rental real estate. In fact, Sec. 1031 has spawned an entire industry of specialists who broker transactions and serve as qualified intermediaries The Qualified Intermediary (also known as an Accommodator) should be a corporation that is in the full-time business of facilitating 1031 exchanges. The role of a QI is similar to, but not identical to, the role of an escrow company. in exchanges. Similarly, componentization has caused the creation of firms that value buildings by asset class as well as advise on proper lives and potential future taxation. They evaluate a building and segregate seg·re·gate v. seg·re·gat·ed, seg·re·gat·ing, seg·re·gates v.tr. 1. To separate or isolate from others or from a main body or group. See Synonyms at isolate. 2. its components into parts or segments that normally are thought of as integral but could be considered removable and able to be categorized cat·e·go·rize tr.v. cat·e·go·rized, cat·e·go·riz·ing, cat·e·go·riz·es To put into a category or categories; classify. cat into depreciable classes. This article focuses on the interaction between these two tax deferral tax deferral The delay of a tax liability until a future date. For example, an IRA may result in a tax deferral on the amount contributed to the IRA and on any income earned on funds in the IRA until withdrawals are made. methods. Like-Kind Exchanges Under Sec. 1031(a)(1), in general "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment." Regs. Sec. 1.1031(a)-1(b) defines "like-kind" as referring to the nature or character of the property and not to its grade or quality. A taxpayer may not exchange one kind or class of property for property of a different kind or class. Regs. Sec. 1.1031(j)-1 requires that the taxpayer group multiple properties exchanged in a like-kind exchange into "exchange groups" of like kind or like class. The taxpayer then computes the gain to be recognized on the exchange and the basis for the assets received in reference to the fair market value (FMV FMV - full-motion video ) of the exchange groups. An exchange group may consist of properties within the same general asset class or product class. Additional rules for exchanges of personal property are enumerated This term is often used in law as equivalent to mentioned specifically, designated, or expressly named or granted; as in speaking of enumerated governmental powers, items of property, or articles in a tariff schedule. in Regs. Sec. 1.1031(a)-2. A taxpayer may determine "like kind or class" by reference to either the general asset classes provided in Regs. Sec. 1.1031(a)-2(b)(2) or the North American North American named after North America. North American blastomycosis see North American blastomycosis. North American cattle tick see boophilusannulatus. Industry Classification System (NMCS NMCS National Military Command System NMCS Not Mission Capable-Supply NMCS New Mexico Computer Society NMCS National Missing Children Services (Canada) NMCS National Motorway Communications System (UK) ) product classes) Under Sec. 1031(d) regarding basis, if property was acquired in an exchange described in Sec. 1031, the basis is the same as that of the property exchanged, decreased by any money or other nonqualifying property received (boot) and increased or decreased by any gain or loss recognized. Boot property takes a basis equal to its FMV. It is important to note that cost segregation, by creating multiple classes of assets, increases the complexity of basis calculations. This determination of basis becomes very important when a taxpayer exchanges real and personal property simultaneously. Recent regulations have clarified the rules for depreciation of property acquired in a like-kind exchange. (4) Cost Segregation If the taxpayer has constructed the building and kept adequate records, the cost of each component is easily found. If the taxpayer has purchased the building, however, establishing the cost of each asset group may require estimating or allocating costs to each group. It is important that a qualified professional performs such a cost segregation study Under United States tax laws and accounting rules, cost segregation is the process of identifying personal property assets that are grouped with real property assets, and separating out personal assets for tax reporting purposes. . The IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. has stated that individuals or firms qualified to segregate costs include those competent in design, construction, and estimating procedures as well as the applicable tax rules. (5) The client can then determine whether the net present value of the resulting tax savings warrants changing the depreciation method for building components that can be classified as Sec. 1245 property. Firms specializing in componentization studies typically charge at least $5,000 and go up rapidly from there. Some firms bill time and costs, and some bill a percentage of the "tax savings." The taxpayer takes the additional depreciation (often called catch-up depreciation) as a Sec. 481 adjustment. The Code allows the deduction to be taken in one year by filing Form 3115, Application for Change in Accounting Method. Under Rev. Proc. 2008-52, (6) a taxpayer may request automatic consent for the change. At one time the IRS routinely denied the automatic consent, making the outcome of the claim uncertain. The Service has since moderated its position, making cost segregation a more feasible planning mechanism. Asset Classification Tests In Hospital Corporation of America, the Tax Court substantially upheld the Sec. 481 adjustment claimed by the taxpayer and allowed it to treat a variety of components of hospital buildings as nonreal property for depreciation purposes. Such assets included floor and wall coverings, partitions, handrails, and elements of the electrical and water systems. The court relied heavily on a 1975 case, Whiteco Industries, (7) in which an outdoor sign advertising company successfully claimed an investment tax credit on outdoor advertising signs. While the case dealt with a different aspect of the Code and not cost segregation, the underlying issue was the same: whether something qualifies as tangible personal property as opposed to real property. The Tax Court in Whiteco set forth a six-factor test for determining the proper classification of an asset: 1. Is the property capable of being moved, and has it in fact been moved? 2. Is the property designed or constructed to remain permanently in place? 3. Do circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or tend to show the expected or intended length of affixation-that is, do circumstances show that the property may or will have to be moved? 4. How substantial a job is removal of the property and how time consuming is it? Is it readily removable? 5. How much damage will the property sustain upon its removal? 6. What is the manner of affixation Noun 1. affixation - the result of adding an affix to a root word sound structure, syllable structure, word structure, morphology - the admissible arrangement of sounds in words 2. of the property to the land? [ILLUSTRATION OMITTED] Both of these cases provide relatively clear guidance as to what items a taxpayer can segregate, and any practitioner who has clients contemplating cost segregation should consult them. In contrast, L. L. Bean, (8) a case contemporary with Hospital Corporation, demonstrates what will not work. In this case, the taxpayer attempted to classify clas·si·fy tr.v. clas·si·fied, clas·si·fy·ing, clas·si·fies 1. To arrange or organize according to class or category. 2. To designate (a document, for example) as confidential, secret, or top secret. an inventory storage facility and its related "racking and picking" system as tangible personal property. The court held the facilities to have included structural components that were either inherently permanent or fully integrated, resulting in real property classification. Splintering an Asset Under Regs. Sec. 1.1031(a)-1(b), essentially any real estate is considered to be like any other real estate. Typically, a taxpayer will recognize no gain, regardless of the amount of gain actually realized, unless the taxpayer receives net boot (including mortgage exchanges). This generous treatment has caused taxpayers to go out of their way to structure dispositions of real estate as exchanges. Cost segregation results in splintering a single real estate asset into multiple assets, most of which are not real estate. What would have been the exchange of one building for another becomes the exchange of bundles of assets, a "multi-asset exchange." The regulations are complex. (9) The exhibit on p. 547 presents an example of cost segregation and a later exchange of the building for another building. The effects of the cost segregation increased the taxpayer's taxable gain Taxable Gain The portion of a sale that is liable to taxation. Notes: When redistributing mutual fund shares that have increased in value, returns may be subject to taxation. See also: Capital gain, Income Tax on the exchange. The example is based, with modifications, on a situation recently encountered by one of the authors. In reality the properties involved in the exchange were mortgaged. The mortgages have been omitted from the example because they complicate com·pli·cate tr. & intr.v. com·pli·cat·ed, com·pli·cat·ing, com·pli·cates 1. To make or become complex or perplexing. 2. To twist or become twisted together. adj. 1. the calculations without affecting the result. Likewise, the example does not reflect bonus depreciation, Sec. 179 expensing, or other more accelerated methods, which generally would tend to further magnify mag·ni·fy v. To increase the apparent size of, especially with a lens. the tax impact of cost segregation on a like-kind exchange. In the example, the client had a cost segregation study performed and elected to change the classification of a significant portion of the assets associated with the building. The Sec. 481 adjustment allowed in the year of change exceeds $220,000. The adjustment results in an immediate tax saving in the year of change, the value of which depends upon the client's overall tax situation; in the highest bracket In programming, brackets (the [ and ] characters) are used to enclose numbers and subscripts. For example, in the C statement int menustart [4] = ; the [4] indicates the number of elements in the array, and the contents are enclosed in curly braces. , the saving could be over $77,000. When a like-kind exchange is made two years later, the result is the recognition of $300,000 of gain, all of which is ordinary income under Sec. 1245 (depreciation recapture depreciation recapture See recapture of depreciation. ). Again, the impact depends upon the overall tax situation, but at the highest rate, the additional tax cost would be $105,000. Had the cost segregation election not been made, no gain would have been recognized because the two pieces of real property would have been considered fully like kind. Thus, on the exchange, the client pays a significant amount of tax that it could have avoided. In this example, the income recognized on the exchange is more than the accelerated deductions from the cost segregation, a result that is clearly disadvantageous dis·ad·van·ta·geous adj. Detrimental; unfavorable. dis·ad  van·ta for the client. Had the exchange gain been less
than the accelerated depreciation, there would have been a small tax
advantage due to the time value of money. However, this advantage would
likely be more than offset by the costs of the cost segregation study
and election.
Another issue a practitioner should examine when contemplating cost segregation is state and local laws regarding the assessment of property tax on real and personal property. The componentization of a building could trigger a reclassification Reclassification The process of changing the class of mutual funds once certain requirements have been met. These requirements are generally placed on load mutual funds. Reclassification is not considered to be a taxable event. of property into a higher tax assessment class. In addition, the CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. may want to research state and local law regarding sales and transfer tax assessments on personal property versus real property. A Potentially Unfortunate Result Cost segregation has become a popular tax saving strategy. While it is a legitimate and often beneficial strategy, it has its drawbacks. One is that reclassifying assets may complicate subsequent like-kind exchanges of the segregated property, often resulting in recognition of substantial gain that the taxpayer otherwise could have deferred. This result can be especially unfortunate because the client may not have received any liquid assets Cash, or property immediately convertible to cash, such as Securities, notes, life insurance policies with cash surrender values, U.S. savings bonds, or an account receivable. in the exchange yet may still be faced with a sizable siz·a·ble also size·a·ble adj. Of considerable size; fairly large. siz  a·ble·ness n. tax bill.
When a client is contemplating a cost segregation election, practitioners should incorporate the possibility of a future exchange of the property into the analysis. Failure to do so can result in a costly outcome in terms of tax liability and cashflows. Editor Notes B. Sue Wood is the principal shareholder of B. Sue Wood & Associates PC, Fort Collins, CO. Donald Samelson is associate professor and director of graduate studies in the Department of Accounting at Colorado State University Colorado State University, at Fort Collins; land-grant with state and federal support; chartered 1870, opened 1879 as an agricultural college, assumed present name in 1957. There is a veterinary teaching hospital, an agricultural campus, and a research campus. in Fort Collins, CO. For more about this article, please contact Dr. Samelson at Don.Samelson@ business.colostate.edu, By: B. Sue Wood, CPA, MS Donald P. Samelson, CPA, Ph.D. (1) Hospital Corp. of Am., 109 T.C. 21 (1997), acq. in part and nonacq, in part, 1999-2 C.B. 16. (2) For more on personal property included in a like-kind exchange of otherwise real property, see Briskin, "Like-Kind Exchanges: Common Problems and Solutions," 36 The Tax Adviser 204 (April 2005). (3) See www.census.gov/epcd/naics07/. (4) T.D. 9314. See News Notes, 38 The Tax Adviser 253 (May 2007), and Stevens, "Depreciate depreciate v. in accounting, to reduce the value of an asset each year theoretically on the basis that the assets (such as equipment, vehicles or structures) will eventually become obsolete, worn out and of little value. (See: depreciation) Property in Like-Kind Exchanges Consistently," 206 Journal of Accountancy 74 (November 2008). (5) See IRS Cost Segregation Audit Techniques Guide, www.irs.gov/businesses/article/0,,~id=134180,00. html, and IRS Letter Ruling 7941002 (6/25/79). (6) Rev. Proc. 2008-52, 2008-36 I.R.B. 587, [section]6.01. (7) Whiteco Indus. Inc., 65 T.C. 664 (1975), acq. 1980-2 C.B. 2. (8) L. L. Bean, Inc., T.C. Memo. 1997-175, aff'd, 145 F.3d 53 (1st Cir. 1998). (9) Regs. Sec. 1.1031(j)-1.
Exhibit: Gain recognized in exchange
Taxpayer T purchases a building and later does a cost segregation
study. T decides to use the component lives. Still later, T exchanges
the building for another building. T purchases the building on
January 1 of year 1 for $1,773,000. After four years:
Cost Depreciation Adjusted basis
Building $1,773,000 $180,013 $1,592,987
The cost segregation study divides the property thus:
39-year property $1,253,500
7-year property 222,500
15-year property 297,000
T makes the election to change its accounting method for the
depreciable lives and is able to deduct $191,574 in catch-up
depreciation under Sec. 481. Two years later, in year 7, T
decides to do a like-kind exchange of the building. At that
time, the adjusted bases of the assets are:
Cost Depreciation Adjusted basis
39-year property $1,253,500 $191,547 $1,061,953
7-year property 222,500 192,707 29,793
15-year property 297,000 130,413 166,587
Totals $1,773,000 $514,667 $1,258,333
The property's FMV at the time of the exchange is $3,500,000,
divided as follows:
39-year property $2,750,000
7-year property 250,000
15-year property 500,000
The building T finds for replacement property has the following
components:
39-year property $2,450,000
7-year property 300,000
15-year property 750,000
T has realized gain of $2,241,667 ($3,500,000-$1,258,333.
Assuming that the components in the 7-year and 15-year property
groups are in the same NAICS product classes, these also qualify as
like-kind exchanges. But under Regs. Sec.1.1031(j)-1 (exchanges
of multiple properties, gain is recognized to the extent that there
is a surplus of FMV of received property over that of relinquished
property.
7-year assets 15-year assets
Relinquished property FMV $250,000 $500,000
Received property FMV 300,000 750,000
Exchange group surplus 50,000 250,000
Gain realized 270,207 583,413
Gain recognized $50,000 $250,000
There is no gain recognized on the 39-year property because the FMV
of the property relinquished exceeds the FMV of the property received.
Had T not elected cost segregation, the building's adjusted basis
would have been $1,502,068. None of the $1,997,932 gain would have
been recognized because the entire exchange would have qualified as
like kind.
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