Market Insight: Guest Articles
Real Estate Opportunities in a Weak Economy
by Anthony “Tony” Saris
Principal, Stadtler Rosenblum Saris
March 22, 2005
In today’s weak economy, many real estate owners are seeking out new ways to increase the cash return from their investments. Some of these investors are finding success from having a Cost Segregation Study (CSS) performed. CSS is the process of reviewing the costs incurred to acquire, construct or improve real estate with the objective of reclassifying qualified assets to shorter lives. The benefits of CSS come from the accelerated depreciation deductions of those qualified assets, which significantly reduce federal and state taxes.
What types of assets qualify for CSS?
Nonstructural assets such as: parking lots, sidewalks, roads and driveways, landscaping, fencing, carpeting, wall coverings, signage, movable partitions, security systems, and special lighting and other items that are primarily decorative in nature have all qualified for shorter depreciable lives. In addition, electrical and plumbing systems related to the operation of the business and indirect costs, such as architect fees and contractor’s overhead, can all be allocated to nonstructural assets.
However, structural assets such as walls, ceilings, floors, windows, doors, elevators, stairs, and fire escapes are considered structural in nature and not subject to the accelerated treatment. Assets related to the operation and maintenance of the building are consistently treated as 39-year or 27.5-year property.
Building owners will not always be aware of CSS and those professionals who work closely with them can bring additional value to the deal. Real estate brokers, loan brokers, lease brokers, attorneys, and insurance brokers can all show their clients additional value by presenting CSS as a cash flow improvement strategy.
Those performing a CSS must have knowledge of a complex set of tax laws and court cases. In some instances, 20-30 year old Tax Court cases still have relevance. On many properties, partial amounts of assets will qualify for CSS and a functional analysis must be completed to determine the exact amount to be reclassified. In fact, the IRS requires a CSS study to be performed in order for a taxpayer to take advantage of the benefits.
Does CSS apply to my property?
CSS is applicable for all investment properties that have been newly constructed or acquired since 1987. Specifically, properties with the best potential for benefits are: shopping centers, strip plazas, hotels and restaurants, medical facilities, as well as traditional commercial and apartment buildings. The benefits are also available for building renovations and tenant improvements. Properties owned by nonprofit entities, however, will not benefit from CSS since they are not subject to taxes.
How does CSS work?
Under the Modified Accelerated Asset Recovery System, commercial property is depreciated over a life of 39 years and residential property over 27.5 years. A completed CSS can support the reclassification of qualified assets (such as those mentioned above) to shorter lives of five, seven and 15 years. The additional depreciation deductions result in tax savings or an increase in cash flow in those early years.
The higher a property’s costs, the more likely the benefit will be significant. In some cases, up to 40% of a property’s costs can be reclassified to shorter lives. On average, this reclassification will yield a tax savings over the first five years of 7%, for every $1 million in structural building costs. For example, consider a new $20,000,000 property with 30% of reclassified building costs from 39-year property to five, seven and 15-year property. This reclassification will generate a tax savings over the first five years of $1,400,000, using a 40% tax rate.
Newly constructed or newly purchased properties can realize the benefits of CSS from day one. Existing properties have an opportunity to “catch-up” the depreciation deductions from 1987 forward. For example, if a CSS of a commercial property purchased in 1998 identifies $3,000,000 of structural costs to be reclassified to 5-year property, all remaining depreciation of about $2,600,000 could be deducted on the tax return in 2003 (the sixth year). Using a 40% tax rate, that’s over $1,000,000 of cash benefit! CSS may even create a net operating loss, which can then be carried back up to 5 years for Federal purposes allowing the taxpayer to claim tax refunds for taxes paid in prior periods.
The newly passed Jobs and Growth Tax Relief Reconciliation Act of 2003 provides another incentive to perform CSS. For qualified assets purchased after May 5, 2003, taxpayers can elect additional first-year depreciation of 50%. For example, CSS reclassifies $1,000,000 of 2003 costs to five-year property. This will result in a “bonus” depreciation deduction of $500,000 and regular depreciation deduction of $100,000 for a total deduction of $600,000, all in the first year!
CSS can provide you with a cash infusion whether you’re purchasing or constructing a new property or are trying to squeeze the most out of your existing investments.