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Savvy developers' best-kept secret: cost segregation.

The nature of when and how cost segregation is being leveraged by developers is changing. More developers are incorporating cost segregation techniques into their construction contracts in order to introduce it as early in the construction process as possible.

Cost segregation (or "Cost Seg," as it is commonly known) is a potent strategy for increasing after-tax cash flow. Essentially, it is a tax deferral tool that leverages an accelerated depreciation schedule. It is applicable to just about any building constructed or purchased since 1987.

The goal is to identify all costs, both direct and indirect, of certain types of property that can qualify for a faster write-off.

It is an IRS-sanctioned practice that could, for example, yield an additional $1.5 million in cash flow on a typical 250,000 s/f shopping center.

IRS guidelines for preparing such a study do not require filing amended tax returns. Also of note, fees for preparing cost seg studies are generally recouped by the client through the first tax year's savings.

The tax benefits are derived through accelerated depreciation on items such as paving, curbing, erosion control, sidewalks, utilities and exterior lighting; and certain building components such flooring, cabinetry and woodwork, appliances and specialty and process systems, to name a few. Further, the tax savings can be realized as soon as the asset is placed in service.

Certain assets are ideal candidates for cost seg due to the preponderance of certain property types that can be reclassified. These include assets such as retail centers, warehouse and distribution facilities, auto dealerships, fast-food outlets and garden apartments.

Starting the cost seg process in the pre-construction phase makes perfect sense. In prior years, most developers came to our firm, Construction Cost Recovery, after the asset was placed in service. But if we deploy cost seg techniques during construction, we are able to use the subcontractors to allocate the costs.

The framework for segregating costs during pre-construction is straightforward. The drawings are reviewed in detail to identify specific construction components and systems that can be reclassified to five, seven, 10 or 15-year property. Such schedules are then provided to the subcontractors.

The construction manager then requires that certain subcontractors submit their trade payment breakdowns in accordance with the established allocations. This ultimately allows a more streamlined and accurate approach to cost segregation.

Most developers understand that this is not an undertaking that can be effectively handled in-house. Preparing a cost seg study requires a skill and understanding of IRS and tax court case law complemented by engineering and cost estimating skills. Tax court case law is constantly changing and a keen knowledge is required of such laws to be able to correctly parse the asset.

It is clear that more and more sophisticated developers are conducting cost seg analysis in the pre-construction phase.

Although Construction Cost Recovery regularly prepares post-construction cost seg studies, it requires more time to analyze all of the invoices along with cost estimating to "reconstruct" the allocations. This methodology leads to greater subjectivity being applied to the analysis.



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Title Annotation:Inside Construction
Author:de Stefanis, Mark
Publication:Real Estate Weekly
Geographic Code:1USA
Date:Sep 1, 2004
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