July 2004
By JAMES S. ANCHIN, CPA
Contractors and their real estate clients have the potential to generate hundreds of thousands of dollars in tax savings by taking accelerated depreciation deductions on real estate. The value of these deductions can be enormous. Not only can contractors reap the benefits themselves if they are building or renovating their own premises, but they can also provide a valuable service to their clients by helping them achieve these tax savings.
For these potential savings, contractors can thank a 1999 court case in which the taxpayer successfully argued that the construction of its hospital was not one indivisible "cost" to be depreciated over 39 years; but also included separate items of tangible personal property. These consisted of HVAC systems, electrical wiring, plumbing, etc., with only a five-year life. Proper engineering studies are needed to support reclassifications.
These engineering studies, more aptly called "cost segregation" studies, analyze the cost of commercial or residential real estate for the purpose of segregating the shorter-lived assets from the cost of the building. These studies make use of AIA forms, change orders, site plans and other documentation, as well as visual inspection. A contractor familiar with cost segregation requirements can be a valuable resource to its client by providing them with the necessary information to properly segregate the costs of the real estate constructed.
With a proper cost segregation study, contractors or their clients, can change certain assets from a 39 or 27-year life to a five, seven, or 15-year life. The size of the deduction won't change, but the timing will, and in the world of deductions, timing is everything.
Consider this: reclassify $1 million of assetsÑwith only $50,000 being reclassified as five-year property, $300,000 as seven-year property and $650,000 as 15-year property, and your earnings on the accelerated deductions is approximately $145,000. And compounding nearly doubles that figure!
How do you get started on these savings? First, your property must have been placed in service after 1986 to benefit from reclassification.
Next, look before you leap. Before expending the time and money on a cost segregation study, companies should first determine whether the effort makes financial sense. A full cost benefit study is always warranted, but here are some rules of thumb to get your feet wet. Take a good look at whether accelerating depreciation will really help you Ñ if there's no taxable income, there's no tax benefit. Also, taking on the reclassification project if you're going to sell the property in the near future does not make much sense because the savings accrue over time (and the entire amount is recaptured when the property is disposed).
To be beneficial, your basis in the property should be at least $1 million. For reclassification purposes, not all projects are created equal. Hospitals, manufacturing plants, residential or commercial projects with major site improvements or decorative additions are the best prospects for reclassification, less so warehouses or similar industrial facilities.
If your cost/benefit analysis yields a "thumbs up," to the project, it's time to actÑthough not without professional advice. Get your documents in order: building site plans, engineer reports, appraisals and business tax returns. Meet with an accountant knowledgeable in the fine points of reclassification. For an existing building you won't even have to amend prior years' tax returns. Thanks to the IRS' automatic change procedure, you are allowed to pick up the cumulative benefit of the prior years' "missed" depreciation all in the year of change. For current, correctly classified acquisitions or improvements, benefits can also be received immediately.
If you have the right situation, tax savings from accelerated depreciation can add up quickly!
About the author: Mr. Anchin is a managing partner of Anchin, Block & Anchin, LLP, a regional certified public accounting firm with offices in New York City and Westchester, that specializes in meeting the needs of contractors in the tri-state area. He can be reached at (212) 840-3456 or by e-mail at: james.anchin@anchin.com