Alright, so you just bought or built a commercial property. Maybe it’s a 70-room hotel or a 5-star resort or even an enormous office complex. Whether you spent $5 million or $500 million, chances are really good that you need to do a proper cost segregation study to ensure maximum and optimal acceleration of depreciation (maximum up front tax deductions and saving). You already know this in theory.
But, depending on the type of property you’re depreciating, you may not realize that you are also throwing money away if you don’t properly segregate the assets within that building for future renovations and abandonment deductions that result from those renovations. Additionally, accelerating tax deductions without proper support could put you in the penalty box with the IRS, when it’s easy to avoid that trap.
I often use the “baked cake” analogy because I so frequently encounter sophisticated and high net worth investors who mistakenly believe that if they have all of the costs of the construction of the building on hand, they don’t need a cost segregation. “My contractor already has all of the costs” or “my CPA already did the allocations.” The problem is that you don’t know from the costing documents or the initial closing statement from your purchase, how to allocate your wiring, plumbing, cabling, and other materials to asset lives and to various components and areas of the building. When you renovate, you just can’t always tell how much of those costs remain on your depreciation schedules, by reference to component, room, office, hallway, etc., in the event of renovations.
When you bake one simple cake from scratch, (picture your average round, plain birthday cake instead of the castle cake pictured above), it can be a lot like the construction of a building in the simplest of ways. You purchase all of your ingredients (eggs, flour, sugar, butter) and you have a receipt with all of your costs. Let’s say you spent $39 and you use all of the ingredients (a dozen eggs, a stick of butter, etc.) so that all of the costs on the receipt are used in making the cake (I know, that’s one expensive cake).
If you think of this cake like a depreciated asset (let’s call it 39-year property), you would write off the cost of your cake over time, $1 each year. If a slice of your cake went bad and you had to replace it, you could easily determine how much of your cost had not been recovered yet, because your ingredients would be equally spread out throughout the cake. If your slice of cake is 1/10th of the cake, you know you’re dealing with 10% of your costs and if it’s year 5 when you replace that slice, then you have an abandonment deduction for the remaining amount of the cost of that slice that you have not yet deducted (34/39ths of $3.90 to vastly oversimplify would still remain on your books), because you would have only written off the first $5.00 of the cake at this point, one dollar for each year.
But buildings aren’t really like that, are they? Most buildings, even the simplest of hotels or office buildings, much like the photo pictured above, have their “ingredients” strewn all over the place in differing size rooms, lobbies, hallways, towers, components, functions and spaces. Thousands of feet of cabling, wiring, plumbing, ceiling tiles, accent materials, light bulbs and more, that were purchased by the truckload, pallet or spool in large quantities, are now line items in your AIA (construction documents) listed as costs by subcontractor, building section, type of material purchased. Or, if you bought the building, you’ve got only one big number, the purchase price.
Let’s get back to our cake. If your building has 100 hotel rooms (or offices) and a lobby and a rooftop and utility rooms and bathrooms and maybe even restaurants, hallways, etc., chances are that the removal or renovation of a section of that building would lead to a lot of head scratching about HOW MUCH of your cost, perhaps listed on your books as 39-year property, you have failed to deduct, so far, at that point. Once you’ve put your cake together, it’s not quite so easy to identify what went into it if you have to take some of it apart.
If you tear out some of your lighting and part of your carpeting and demolish wing X or hallway Y, do you really know how much of the cost of the lighting, carpeting, woodwork, wiring and other materials is allocated or can be allocated to those materials you’re throwing in your dumpster from that section of the building? If you don’t, you’re either going to miss out on a big tax deduction (abandonment deduction) for the un-depreciated life of that asset (a deduction you’ve not taken yet), or you’re going to risk overstating it and having the IRS ask you a lot of questions about how you came up with your numbers.
Abandonment deductions are not the only trap for the unwary property owner who fails to conduct a proper cost segregation. When purchasing a building that was constructed by a previous owner, many owners will make the mistake of relying on an appraisal or “residual” approach. This means that an assessment is made of what assets in the property are clearly “short life” assets (carpet, accent lighting, paving) and placing a value on them. Everything else is considered 39-year property. This sounds good in theory because you get bigger deductions up front if you call a large percentage of your property “5-year” or “15-year” property and write off the expense earlier rather than later.
But the IRS is keenly aware that reports like this are weighted a little too heavy in favor of short life assets (bigger tax deductions up front) and without appropriate (or any) documentation of how the 39-year property was valued.
Usually, it’s just what’s left over (residual) that is tossed into the 39-year column and that raises some big flags with the IRS, according to their own site and the Cost Segregation Audit Techniques Guide that they ask taxpayers to rely upon.
The risks of following this method for cost segregation are similar to those relating to abandonment as noted above. That is to say that an improper approach to cost segregation will leave the taxpayer without a sufficient amount of property allocated to short life (for fear of red flags) or an allocation that is too aggressive without appropriate documentation.
The solution: an engineering-based cost segregation that breaks out all of your costs into asset lives and building categories and allocates them across the property. The result of this approach is a report, which ought to include a hundred or hundreds of pages of detail, that breaks out all of your costs by material and by linear foot, square foot, component and location within the building. The amount allocated to short lives will almost always be much higher (bigger tax deductions) and the owner will have a cost blueprint or MRI of the building for all future renovations and changes in the building.
Now, you’ve matched your eggs, sugar and flour by cost and quantity to any piece of cake in any part of the cake that you choose to take a slice of. Enjoy!