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The Power of Cost Segregation: Are You Tracking Your Tenant Improvements Properly?
Publication:
New York Real Estate Journal (April, 2007)
Author:
Jacob D. Hopper
The popularity of cost segregation
is spreading like wild fire.
This highly effective tax planning
strategy, which can be used with
new construction, acquisitions
and properties already in service,
can often free up hundreds of
thousand or millions of dollars in
immediate cash flow. This increasing
popularity is also shining new
light on the ongoing management
of depreciation for real estate.
Most owners taking advantage of
this highly effective strategy only
consider the immediate and short
term impact of accelerating depreciation.
Although this is certainly
the driving force behind a cost
segregation study (CSS), there are
other important benefits as well.
One area this applies is tenant improvements
which are commonly
overlooked opportunity.
Overview of Cost Segregation
Cost segregation studies are
used to accelerate depreciation
deductions, defer income tax,
and improve cash flow. These
studies allow property owners to
accelerate deductions by identifying
components of their buildings
that can be depreciated over five,
seven, and 15 years as opposed
to the standard 39 years (27.5 for
residential). Qualifying elements
can include certain types of lighting,
millwork and wall covering as
well as a portion of the building’s
electrical and mechanical system
to name a few. Site improvements
such as curbing, sidewalks, drainage
and landscaping also qualify.
The process, which is based on
a detailed engineering analysis,
involves an in-depth review of
all relevant property information
including cost data, lease agreements,
and building plans as well
as a thorough on-site inspection by
the cost segregation engineer. The
engineer then dissects the building
costs and classifies them to
the appropriate depreciable lives.
Soft costs such as engineering,
fees, builder’s overhead and profit
and construction period interest
are then allocated in accordance with the findings of the CSS. The
result is a comprehensive report
which includes a detailed breakdown
of costs associated with the
property.
Case Studies
To better illustrate the impact of
cost segregation let’s look at a few
case studies. On average, a CSS
performed on an office building
will allocate 7-15% of depreciable
costs to personal property (five
or seven year). Properties is rural
settings with site improvements
typically allocating an additional
5-15% to land improvements (15
year).
Case Study A
Property A is an 18-story office
tower in a downtown setting. The
total gross building area is approximately
480,000 s/f. The tax
basis is $100 million net of land and
does not include furniture, fixtures
and equipment. The property was
built in 2000 then acquired and
placed in service in May of 2006.
The CSS was completed for the
new owner immediately following
acquisition.
Case Study A: Post CSS Allocation |
Personal Property 5 - Year $7,337,377 7.3% |
| Personal Property 7 - Year $863,053 0.9% |
| Real Property 39 - Year $91,799,571 91.8% |
| Total Depreciable $100,000,000 100% |
Case Study A: Financial Impact |
| Additional Depreciation (year 1) = $1,400,000 + Additional Depreciation (years 1-5) = $6,400,000 + 10-year NPV = $2,260,000 + 40-year NPV = $1,600,000 + NPV calculated using a 40% tax rate and 6% discounted rate. |
Case Study B
Property B is a 4-story office building with a lower-level parking
garage located on a 5.8 acre site.
The total gross building area is
approximately 136,000 s/f. The tax
basis is $24,271,276 net of land and
does not include furniture, fixtures
and equipment. The property was
newly constructed by the current
owners and placed in service in June
2006. The cost segregation study
was conducted shortly after the
building was placed in service.
Case Study B: Post CSS Allocation |
| Personal Property 5 - Year $3,807,249 15.68% |
| Land Improvements 15 - Year $1,323,704 5.45% |
| Real Property 39 - Year $19,140,324 78.86% |
| Total Depreciable $100,000,000 100% |
Case Study B: Financial Impact |
| Additional Depreciation (year 1) = $756,000 + Additional Depreciation (years 1-5) = $3,480,000 + 10-year NPV = $930,000 + 40-year NPV = $1,270,000 + NPV calculated using a 40% tax rate and 6% discounted rate. |
Tenant Improvements
Although cost segregation is routinely
utilized by building owners
these days, most studies typically
overlook the importance of detailed
cost breakdowns for each tenant. In
most cases the study will not separate
or group the costs by individual
tenant, but rather put all costs into
a single table. Although the initial
benefits of the study should be the
same either way, the future benefits
associated with the two approaches
will not be. A study that groups
costs by tenant can be a powerful
asset management tool throughout
the life of the property.
Grouping costs by tenant is
important because it creates a defensible
position to support future
write-offs. It also provides for a
cleaner depreciation schedule as
tenants move in and out and renovations
are made. Let me explain.
Landlords who make contributions
towards tenant improvements
capitalize these costs and depreciate
them, mostly over 39-years in
the absence of a CSS. When a tenant
leaves, their former space is often
gutted or renovated significantly for
the new occupant. If the landlord
has a detailed breakdown of costs
for the space being renovated, before
any of the work is done, then
they will know what materials are
being removed and retired from
service. The undepreciated values
of these materials can be written-off
in the current tax year. However,
when there is no detailed record,
the landlord is forced to carry assets
that no longer exist (ghost assets) on
their depreciation schedule for the
remainder of the depreciable lives.
This is no small amount of money.
Think about some of the space you have recently renovated.
The best time for a CSS is immediately
following acquisition or
construction. Ideally, you will have
a study performed on the property
when it’s placed in service. Therefore,
any changes you make in the
future, including tenant improvements,
can be properly addressed
from a tax and depreciation perspective.
Materials removed from
the property can be written-off and
you will no longer have to continue
depreciating assets that are now in
the dumpster.
While we’re discussing tenant
improvements there is an important
update that you should all
know about and it’s great news.
Qualified Leasehold Improvements
(QLIs) are back. The Tax Relief and
Health Care Act of 2006 retroactively
extended the deadline for this
special treatment from December
31, 2005 to December 31, 2007.
This provision allows taxpayers to
depreciate “qualifying” improvements
using a 15-year straight
line recovery period instead of the standard 39-year period, which can
significantly improve cash flow.
Note that there is still a significant
opportunity to identify 5 and 7-year
assets as well.
Impact of QLIs |
| $100,000 allocated to 15-year SL vs. 39 SL 10-year NPV savings = $11,939 40-year NPV savings = $10,845 NPV calculated using a 40% tax rate and 6% discounted rate. |
Generally, a QLI is any improvement
to an interior portion of a
building that is nonresidential real
property, provided all of the following
requirements are met:
• The improvement is made under
or pursuant to a lease by the lessee
(or any sublessee) or the lessor of
that part of the building. A binding
commitment between related persons
is not treated as a lease.
• That part of the building is to be
occupied exclusively by the lessee
(or any sublessee) of that part.
• The improvement is placed in service more than 3 years after the
date the building was first placed
in service. This is when the building
was first placed in service, not
when the current owner purchased
the building.
However, a QLI does not include
any improvement for which the
expenditure is attributable to any
of the following: The enlargement
of the building; any elevator or
escalator; any structural component
benefiting a common area or the
internal structural framework of
the building.
If you are planning improvements
for a tenant this year, which
you’ll be paying for, keep the cut
off date of December 31, 2007 in
mind. The difference between placing
the improvements in service
on December 31st of 2007 verses
January 1st of 2008 can be very
substantial. I met with a prospective
client recently who will realize approximately
$200,000 in additional
net present value savings on a $2.5
million tenant improvement if
they can make the December 31st
deadline.
Not all cost segregation studies are the same. Very
few providers will take the time
to fully explain the options and
additional benefits. This may be
due to a lack of understanding
or because they simply want to
submit the most competitive bid
possible. A CSS that separately
groups improvements by tenant
will generally require more work
and therefore cost more. The additional
cost is often minimal, but
in an industry that’s getting more
and more competitive, less experienced
providers are doing whatever
they can to keep prices down and
profit margins up. An experienced
provider will explain the options
and help an owner make a decision
based on needs and total value, not
simply on price. We all know that
the old saying is true - you get what
you pay for.
