Study building costs to up cash flowBaltimore Business Journal – by Gary Anderson 

Optimizing your investment

 
Cost segregation, though known by many real estate owners, is sometimes overlooked.

It is a methodology used to reallocate certain building costs into separate identifiable components that can be depreciated over shorter lives. The primary purpose of a cost-segregation study is to reallocate as much building costs between land improvements and tangible property. The more costs allocated to tangible property, the greater the desired tax benefit. Tangible property creates tax benefits because it is depreciated over five or seven years while normal building costs are depreciated over 27.5 or 39 years.

A cost-segregation study may be performed for real estate already in service, for new construction and acquisitions. Generally, it is easier to analyze a building’s cost structure during initial construction or expansion since building plans are readily available and can be utilized to identify various components that may qualify as tangible property.

Costs that may be reallocated to land improvements consist of, but are not limited to, certain landscaping, sidewalks and fencing which are depreciated over a 15 year recovery period.

Costs that may be reallocated to tangible property include movable partitions, furniture, removable carpeting and wallpaper, certain fixtures and window treatments. Support systems that are needed to run certain equipment or machinery could be considered tangible property under certain circumstances.

There are several internal levels of cost-segregation studies ranging from a detailed engineering approach through a less formal rule-of-thumb appraisal. The Internal Revenue Service prefers the engineering approach since it will produce the most accurate results.

All businesses that acquire, construct or renovate real property would benefit from a cost-segregation study.

The real benefit of a properly documented cost-segregation study is the enhanced depreciation deductions it yields. A major advantage of the study is not necessarily that it produces more depreciation deductions, but that expenses accelerate more rapidly, producing a greater benefit due to the time value of money.

The ability to write off specific components identified as they are replaced is yet another advantage. For example, when a study is performed, the cost of the roof would be specifically identified. As the roof will eventually be replaced, the remaining cost could be written off.

One disadvantage of a cost-segregation study is the potential triggering of depreciation recapture and possible understatement penalties a taxpayer could incur for studies that are too aggressive in classifying costs. To avoid penalties and pass IRS scrutiny, the study must be objective and supported by contemporaneous records. Studies supported by an engineering study add credibility and produce the most accurate cost allocations.

Overall, cost-segregation studies can produce tremendous tax savings for those who build, acquire any business that builds, acquires or renovates property. The increased tax savings increase cash flow, which in turn, businesses can reinvest.

Gary Anderson, a certified public accountant and senior manager at Reznick Group P.C. in Baltimore, can be reached at gary.anderson@reznickgroup.com.

I’ve talked to several potential investors recently that were not aware that there are multiple benefits of commercial real estate investing. 

Investment Basics

When investors buy any commercial real estate they are acquiring a revenue stream.  Admittedly there are a few signature buildings that are so iconic that they are a ”pride of ownership” acquisition, but most properties are valued solely for their future economic potential.  There are four primary ways in which investors benefit from their acquisitions:

1. Cash Flow

is the sum of:  Cash In - Cash Out.  The primary source of inflow cash is rent.  Pet rent, late fees, laundry and owner contributions are also part of the cash in stream.  Cash Outflows include taxes, expenses and distributions to owners.

Owner types vary widely on the importance they place on distributions:

• Residential Multifamily properties (2 to 4 units) and smaller Commercial Multifamily properties cast off little cash.  Their owners tend to focus more on equity gained at the time of disposition. 
• Investors of larger properties often use cash flows (distributions) as a primary source of spendable income.  They certainly expect gains at sale, but they often will use that gain to step up in basis to acquire a larger asset in the hope of increasing the monthly cash-flow. 
• The bane of all investors is the much dreaded Cash Call.  When cash out ‹ cash in to the extent that operations are impacted, the property owner(s) are forced to add cash to keep expenses current.  Because of their focus on maintaining regular, dependable distributions, the owners of larger properties tend to have lower LTV loans.  This doesn’t eliminate cash calls, but it does make operations inherently more stable, reducing the likelihood of requiring additional cash.

2. Appreciation

is Future Disposition Price - Original Acquisition Price.   A 53 unit complex that is purchased for $3.2 million is 2007 appreciates $700,000 if it is sold for $3.9 million several years down the road.  (more…)

If you use a standard broker there’s not much benefit to calling very far ahead of making a move.  Of course, I suggest employing a full service wealth development specialist (WDS).  I suggest that the initial conversations start 1-2 years prior to disposition and 6 months ahead of acquisition.  I provide these consultations without charge…so do many other client centric investment brokers.  Perhaps you should stop reading this and call.

Planing Improves Profits!

 Dispositions

The primary reason for starting early is to prepare your Due Diligence Package formatting.  A, well organized complete package will separate your property from others with similar revenues in similar condition.  Buyers and Banks factor for risk.  Key components of risk are items that are unclear or unknown.  By starting your Due Diligence Disposition package early you can instruct your Professional Management company how you want expenses reported. 

We want costs shown as Operational Expenses only if they are indeed directly related to operations.  The same is true of revenues.  Instruct your manager to keep all extraordinary and capital expenses accounted for separately.  It’s simple:  building a new parking lot is cap-ex; stripping the old parking lot is operations.  The reason that’s important?  Take the case of a 53 unit apartment that spent $68,000 switching out their single paned aluminum windows and sliders for Argon filled vinyl.  The individual heat bills dropped by $15/month, the appearance was upgraded, and the units are less drafty…clearly improvements.  But poor reporting of expenses would reduce the value when evaluated by Cap Rate by inflating the expenses by $68,000:

Imagine improvements to your property reducingits value! A good broker would likely have figured this out during due diligence once the property was under contract…but it would (more…)