Summary:  Cost Seg. is an underutilized strategy that commercial real estate investors can employ to reduce their taxes, improve their ability to fund new properties and increase their purchases.  Below I have adapted information provided me by one of the nation’s leading authorities on Cost Segmentation Studies.

As we all have enjoyed our Holiday Season, sadly the next event we face involves the perennial tax deadlines.  This year you could apply cost segregation and save considerable money. Cost Segregation is the least utilized and most cost efficient way to save tens and even hundreds of thousands of tax dollars on the commercial properties that you own, represent or manage. Unless you take action soon, you will forgo these tax deductions.

Reasons why you should learn more about Cost Segregation: Cost segregation is the spigot that taps the hidden “cash flow” in every commercial property, including apartments. Less than 10% of all commercial property owners have utilized cost segregation. The reasons vary but in general it is due to a lack of awareness and because the 1997 Supreme Court ruling requires than the cost segregation be prepared by an independent cost-engineer – not an accountant. In addition up until 2001, the cost of cost segregation services were prohibitive – this is no longer true.

Recent court rulings and changes in IRS filing procedures make this tax savings benefit fully accessible to owners of any size commercial property.

Property owners now need only file a single form accompanied by a cost seg report prepared by an independent cost engineer — no costly, formal, multi-stage appeal process is required. You can even file for a previous year’s reduction in Federal and state taxes. All these funds are “hidden cash flow” for the business owner. These monies become a new source of investment capital. In addition to these Federal tax benefits there are other significant monetary gains.

Big Dollar Returns – TRIFECTA of Cost Seg

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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.

• Appreciation gains can occur from (external) market forces such as a downward trend in Cap rates, or from increases in rent relative to expenses due to high demand.
• Gains can also be “forced” by internal forces.  This occurs when we reposition a property.  Renters will pay more for upscale amenities and newer looking accommodations.  Success requires having the amortized costs of improvements be exceeded by the increased rents.  In some cases we merely seek to raise the rents on the existing renters; other times we are using the upgrades to attract a new tenant profile.

3. Loan Paydown

is determined by subtracting the initial loan amount from the remaining loan balance at any given time.  Suppose a $3,200,000 property is acquired with a roughly 65% LTV loan at 6% with a 30-year amortization.  Day one the beginning loan balance would be $2,000,000.  42 months later (3-1/2 years) the loan balance would be $1,909,649.  The loan paydown amounts to $90,351 for that period. Read more

One of the ways we deliver value to investors is to inform them of the benefits of Cost Segregation and to offer a free Cost Seg Feasibility Study. CS doesn’t apply in every situation, but the possibility of saving clients tens or hundreds of thousands of dollars is too much to pass up.

In essence, CS employs greatly accelerated depreciation on commercial real property assets. The improvements (not raw land) of a commercial real property are broken down into their components and then rated for their cost and remaining life. The building improvements are classified as either Section 1245 or Section 1250. S-1245 (basically tangible personal property) is the primary source of Investment Tax Credit savings. I will differentiate property types and the process of Cost Seg in a series of future posts.

This process is typically performed by Cost Engineers, not Cost or Tax Accountants.

Properties are normally depreciated at 27.5 years (multifamily) or 39 years (commercial and industrial improvements.) Clearly a washer and dryer have a shorter useful life and…cost seg permits depreciating that at a pace that reflects its actual remaining useful life.

Disspelling Cost Seg myths:

MYTH 1: “Cost Seg will increase my Alternative Minimum Tax payments.” Wrong! AMT will reduce the positive impact of Cost Seg slightly..but only slightly. It certainly does not increase AMT. My opinion: If I can save a lot on taxes, I’m in!

MYTH 2: ”CS is not fullytested.” Wrong! There is significant case law on this item; the IRS is well aware of the provisions. Read more