Monthly Archive: December 2012

Cost Segregation

Cost Segregation is a tax savings strategy that in my view defies logic. The underlying theory supporting Cost Segregation is at best a stretch of the truth, and at worst, an outright deception.  Yet the US Tax Court decided in a 116 page July 27, 1997 opinion that Cost Segregation is legal.  For those who want read the case, here is the link:

http://www.ustaxcourt.gov/InOpHistoric/HCA6.TC.WPD.pdf

So what is Cost Segregation and how can applying it to commercial real estate lower your income tax bill?  The concept started in the early 1970s with the very popular investment tax credit.  You purchase qualified property and you got the credit.  Special accelerated depreciation  rules were  enacted for this investment tax credit property and treasury regulations created a classification for real property called  “structural components”   The more structural components of a building you had, the larger the ITC and depreciation you could take.  Put a mortgage on the whole deal, put little of your own money down, and write off the interest as well.  It was a great deal while it lasted.

Now fast forward to 1986.  The Tax Reform Act that year repealed the ITC, and lengthened depreciation schedules. All of a sudden commercial property gets a 31 year life rather than 19.  (Just so you know, it’s 39 years now).  To make matters worse, passive real estate losses were eliminated as offset to ordinary income.  Almost overnight with no ITC and dramatically reduced depreciation, commercial real estate generated little annual tax benefit.  Taxpayers looked to their CPAs for relief.   CPAs began to look for a tax savings strategy and sure enough, the tax professionals discovered, or uncovered I should say, “component” classification of a building.  Furthermore, by “segregating” certain parts of a building into categories of movable property, the CPAs and Structural Engineers came up a way to legally circumvent in my opinion the congressional intent of the 1986 reform act.  With the US Tax Court eventually giving its blessing, and the IRS  acquiescing, a multibillion dollar Cost Segregation analysis industry was born to “segregate out” the cost of the tangible portion of a building.   With about $15k in hand, and a good engineering analysis the CPAs were able to confidently and legally rapidly depreciate substantial parts of commercial buildings on annual tax returns.

Let’s take a look at an example of how this works.  Let’s say you all purchase a commercial property for $30M (not including land) which has already been leased with triple net tenants prior to completion.  Without the benefit of a Cost Segregation analysis, you would be required to depreciate this baby over 39 1/2 years or approximately $759,494 a year as a write off.  However with Cost Segregation, you are able to write off some of the asset at a much faster rate which could save you millions in taxes over the life of the building.  How much you can write off at the rapid rate and how much tax you can save depends on how sophisticated an engineering analysis you can provide to the IRS.

What are my thoughts?  Congress should simply enact legislation to allow for rapid depreciation of a certain percentage of real property and do away with all this “cost segregation”.  For example, Congress could estimate the average tax savings at the national level of cost segregation.  Then all taxpayers could elect a safe harbor percentage of their newly purchased building for rapid depreciation.   Or in the alternative, Congress could change 39 years of misery into a very acceptable 20 year happy deal.   Very simple, very easy; but that would be too easy and too simple.  And as we all know, there is nothing easy or simple about the United States Income Tax Code.  And one more thing please:  Due to the complex nature of cost segregation analysis consult your tax professional before trying this on your own.