Cost Segregation: Important Questions and Answers

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Cost segregation specialist Steve Erwin answers some of the most frequently asked questions concerning cost segregation analysis.  Feel free to send us any additional questions that we haven’t addressed here.

Q. Doesn’t my CPA already do cost segregation studies for me when they prepare my taxes?

A.Almost always, the answer is no.  It is possible your CPA is taking what is known as a “rule-of-thumb” approach and allocating an estimated percentage of the total project cost to the various components of your restaurant facility.  This is not recommended by the Internal Revenue Service, nor would it substantiate your tax return if the agency ever audited your restaurant.

A general practitioner may be able to determine that you have a heart condition, but that doesn’t mean he can operate on your heart. Similarly, most CPA firms are capable of explaining the benefits of a cost segregation analysis but don’t have the experience and resources to execute one correctly.
A cost segregation analysis requires a vast understanding of construction methods, the ability to interpret blueprints and estimate construction costs of building components.

Q. Why not use an engineering firm for my cost segregation analysis?

A. Although an engineering firm is qualified to estimate all of the costs associated with building or acquiring a property, it will almost always lack the understanding of the important tax matters that could be involved in a study.

A restaurant should be very cautious when considering a cost segregation study if engineers aren’t also analyzing potential 1031 exchanges, Sections 1245 and 1250 recapture, sales, passive losses, negative basis or net operating losses.
Although a cost segregation study can be executed in all of these scenarios, the ability to plan for the effects of these issues is crucial in order to put a client in the most beneficial tax situation.  This is best handled by a firm that has both engineering and tax expertise.

Q. If we can internally determine what we think is qualified property for accelerated depreciation, why would we need a third-party cost segregation study done?

A. Although you may be able to identify some of the obvious components, such as carpet, decorative lighting and land improvements, it is likely you will overlook ambiguous items that qualify for accelerated depreciation and miss out on thousands of dollars worth of tax deductions that you are entitled to.

The engineers that specialize in cost segregation studies are able to identify qualified items such as dedicated electrical, plumbing and excavation work only related to parking, landscaped and sidewalk areas and various components of your property that aren’t easily identifiable from an invoice or general contractor’s application for payment.

The IRS recommends using a third party for cost segregation studies.

Q. Will I have to amend past tax returns if my property was placed in service prior to the current tax year?

A. No, Section 2.01 of the Appendix of Revenue Procedure 2002-9 allows an automatic change of accounting method.  In certain cases (like a taxpayer being under audit) permission needs to be granted, but past returns do not need to be amended.
The form for making the change in accounting method (Form 3115) answers a myriad of frequently-asked questions and shows a calculation of the depreciation adjustment, post cost segregation study.

Q. Does cost segregation have any effect on the resale value of your property?

A. No, cost segregation won’t affect the resale value or market value of a property.  However, you may end up paying more in taxes when you do sell your property since cost segregation increases your tax deductions before the sale.  There is an option to defer your tax gain if you buy another piece of real estate.

If a cost segregation study is executed on a property that is later sold to an outside party, the property classifications can be carried forward to the future owner.  Essentially, the future owner of the property will eventually receive the entitled tax deductions a cost segregation study has identified for the building without paying for the study.  Since the fee is somewhat small compared to the cost of a restaurant, it shouldn’t be considered a major selling point.

Before hiring a cost segregation specialist, discuss and determine the tax consequences of future scenarios, such as the sale of the property, a 1031 exchange to defer taxes or a sale of partnership interests or shares in the company to other partners or shareholders.

Q. Don’t I risk an audit by doing a cost segregation analysis?

A. Audits are always a possibility with or without a cost segregation analysis.  The IRS is very familiar with the code section, regulations, revenue procedures and case laws that support the performance of a cost segregation analysis.

The IRS has published guidelines of what constitutes a properly performed cost segregation analysis.  The agency has also published field directives on the application of cost segregation studies in the restaurant industry.

If your cost segregation specialist follows all of the IRS guidelines and directives and is up to date on current codes, regulations, procedures and case law, a tax audit will be a much less worrisome experience should it occur.

Q. How much does it cost?

A. The price of a cost segregation analysis will vary depending on your specialist’s fees.  During your initial consultation, request a price quote and a net present value estimate.

Net present value is a calculation that shows the value of a cost segregation study over the remaining tax life of a property.  The annual value is adjusted back to today’s dollars, allowing you to compare the total benefits of your analysis to its cost.

Generally, the net present value you will earn after tax savings by utilizing a cost segregation study will be at least 10 times the cost of the study.

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