by Vinny Botta
In today’s competitive marketplace, contractors look for ways to leverage signature services to win bids, as well as provide the best service possible to their clients. Working in tandem, contractors can leverage Withum’s cost segregation strategies to their client’s benefit. In an effort to save capital in the short term to fund capital projects, or to realize an earlier return on investment, a cost segregation study can put contractor’s clients in a position to succeed in their endeavors.
A cost segregation study is a strategic tax saving tool that allows companies or individuals to increase their cash-flow by accelerating depreciation expense and deferring their federal and state income taxes. In general, for real estate, the value of the building and its components are limited to depreciation over a 27.5-year period for residential rental property (i.e. apartment buildings, nursing homes, assisted living facilities, etc.) or a 39-year period for nonresidential real property (i.e. office buildings, car dealerships, hotels, retail centers, etc.).
“Significant real estate projects will often have millions of dollars invested in 27.5-year property or 39-year property, which significantly defers the return of the invested capital.”
A cost segregation study can be applied to purchased, renovated or newly constructed properties. A taxpayer can reclassify certain building components over shorter tax lives that will allow for faster cost recovery/depreciation, rather than using 27.5 years or 39 years for the entire project. The cost segregation process is far from simple and faces considerable scrutiny from the Internal Revenue Service (IRS) when not done properly, thus the importance of using a seasoned cost segregation firm.
The complex nature of a cost segregation study requires significant record keeping and documentation for proper segregation. For a newly constructed building it is preferable for the documentation process to begin at the commencement of construction planning. Without the proper documentation, the study may not be substantial enough to prove worth, or may simply hinder the process of a proper study. A tandem relationship working at the goal of a cost segregation strategy could prove to be beneficial to not only the client receiving tax benefits up front on their investment, but also the builder in a commitment to providing excellent service.
The IRS accepts various methods in performing a cost segregation study, but the preferred method is to use a detailed engineering approach to actual cost records. In general, it is the most methodical and accurate approach, relying on solid documentation of the construction costs and minimal cost estimating for newly constructed properties. Original documents such as construction drawings, engineering specifications, contracts, job cost reports, change orders, payment requests and vendor invoices are used to determine which costs can be reclassified to shorter lives under MACRS depreciation.
This engineering-backed approach will provide the most rigorous and accurate results in overcoming IRS scrutiny rather than the other less methodical and structured approaches presented above. This is why it is important to have contractors on board early with implementing a plan that will provide the best records and evidence for the segregation.
Not all cost segregation studies are the same. A taxpayer should be aware of what areas the IRS will consider key factors in a cost segregation study and be sure to use a reputable cost segregation firm.
Vinny Botta, CPA, CGMA, is partner at WithumSmith+Brown, PC.