Cost segregation studies, or cost segs, have been a widely used accounting tool by real estate investors as a way to preserve capital and realize significant tax benefits through accelerated depreciation, asset reclassifications and easier write-downs when assets are disposed of. However, with tax reform, many investors are asking whether or not cost segs will continue to benefit them.
“The story today is about how tax reform might affect the cost segregations industry,” says Kevin Mowatt, Northeast practice leader at the consulting firm RSM’s tangible property services group in New York City. “The best way to look at cost segs is that they are an IRS-recognized tool that helps companies exploit the time value of money or TVM.” The concept of TVM is that money available today is worth more than the same amount down the road. The types of companies most likely to benefit from cost segs are those that have been consistently profitable and are looking to offset their current tax liabilities, according to Mowatt. “If a hotel chain or a retail property owner is consistently running at a net operating loss (NOL), then cost segs probably aren’t for them.”
For example, a rapidly growing data center operator RSM has worked with made almost $200 million in capital expenditures in just a few years. The company was searching for ways to reduce its tax burden. The cost segs study enabled the company to apportion its capital expenditures appropriately between 39-, 15- and 5-year tax lives in order to accelerate depreciation and generate significant tax savings.
In another example, a multi-billion dollar bakery in Massachusetts realized $930,000 in savings using cost segs. The company had outgrown its existing space and wanted to purchase a manufacturing facility that would suit its future needs. It was able to allocate the purchase and build-out costs among 39-, 15- and 7-year categories in order to accelerate depreciation and improve cash flows. The net result was the bakery was able to reclassify about 6 percent of the purchase price of its new facility as 15-year land improvements and approximately 65 percent of the renovation costs of the new facility to a 7-year property.
Signs are emerging that cost segregation studies will remain a useful tool for real estate investors. “We regularly commission cost segregation studies that allow our investors to accelerate depreciation in the shortest amount of time according to the law,” according to Matthew Baltzell, a real estate analyst at the private equity firm Boardwalk Wealth in Dallas, Texas. His firm connects international investors with U.S. based multifamily opportunities. He adds that as of September 28, 2017 “if you were to buy a property after this date, you can now take bonus depreciation on any property purchased after this date.”
Depending on their situations, real estate firms that have filed extensions or are willing to file amendments to their 2017 returns, can now apply some of their future depreciation against a current higher tax liability, says Walt Batansky, CFO at Avocat Group, a commercial real estate services firm.
Cost segs studies generally take about two to four weeks to be completed and should be undertaken as soon as a property is acquired, constructed or renovated, according to Mowatt.
However, cost segs do come with some risk. When engaging a third-party firm to conduct the study, investors should look for firms that employ professionals with strong engineering, architecture, construction and tax accounting backgrounds. Professionals who lack a deep engineering and construction background are often unable to realize maximum savings for their clients because they lack industry expertise.