- Email: [email protected]
Tax savings through cost segregation
TAX TIPS Tax savings through cost segregation Kenneth E. Hicks, C.P.A., and Riley Nelson, C.P.A.
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ost segregation can provide optometrists with significant tax savings and increased cash flow through the use of accelerated depreciation deductions on real estate. Generally, nonresidential real property must be depreciated straight line over 39 years. Using cost segregation, nonstructural components of buildings can be classified as personal property, accelerating depreciation deductions from 39 to 5 or 7 years. Cost segregation does not allow any
Cost segregation studies can help to increase cash flow and reduce tax liability. Here are the advantages and disadvantages of having a cost segregation study done for an OD practice. additional depreciation over the life of the building. Rather, it allows more depreciation in earlier years thus reducing tax liability and increasing cash flow. The court cases that follow present a background for cost segregation and show how it has been used to reduce tax liabilities. The court case Hospital Corp. of America v. Commissioner, 109 T.C. 21 (1997) was significant in defining current cost segregation. Hospital Corporation of America (HCA) constructed hospital facilities over several years. HCA classified some of the cost of constructing the hospital facilities as personal property and deducted them over 5 years. The Internal Revenue Service took the position that the items were structural components of the buildings and must be depreciated over the same period as the building. The court ruled in favor of HCA and stated that some items qualified as personal property. Several items in the HCA case that qualified for personal property included: ● Wiring related to television equipment ● Carpeting Kenneth E. Hicks, C.P.A. is Senior Partner in the firm of May & Company, LLP. Riley Nelson, C.P.A. is a member of the Professional Staff of May & Company, LLP. The firm consults with optometrists in 28 states, assisting with their tax planning and preparation, QuickBooks support, and business planning. May & Company was established in 1922 and has offices in Louisiana, Mississippi, and Alabama. They can be reached at 601-636-0096 or by e-mail at [email protected]. The opinions expressed are not necessarily those of the American Optometric Association.
Vinyl wall coverings Kitchen water piping Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975) is another major case that helped develop cost segregation. This case set out specific questions to ask to determine if property is considered personal property. The 6 factors the case established as qualifications for eligibility in the personal property category include: ● Can the property be moved and has it been moved? ● Is the property designed or constructed to remain permanently in place? ● Are there circumstances that show that the property may or will have to be moved? ● Is the property readily movable? ● How much damage will the property sustain when it is removed? ● How is the property affixed to land? A cost segregation study must be done before any property in question is classified as personal property. The study is conducted to see how components of a building can be broken down and classified. Before a study is performed, it is important to do a cost-benefit analysis to determine if the study will be beneficial to the taxpayer. Some of the factors in determining if a study should be performed include: ● The cost of the property ● The type of property ● If the property is new or an existing structure Generally, a cost-benefit analysis can be performed by the firm preparing the study, at no charge, to determine if the cost segregation study should be performed. ● ●
Performing the study Cost segregation studies can be performed on buildings under construction; existing buildings that have been renovated, remodeled, restored, or expanded; existing buildings being purchased; and any building purchased after 1986 in which cost segregation studies have not yet been performed. Cost segregation is performed by having an expert, such as a construction engineer, complete a study dividing building cost into 4 types of property: land, real property, land improvements, and personal property. ● Land is nondepreciable property. Land is the least advantageous property type because no cost recovery is allowed until the property is sold.
1529-1839/06/$ -see front matter © 2006 American Optometric Association. All rights reserved. doi:10.1016/j.optm.2006.01.022
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Practice Strategies Personal property has the most advantageous cost recovery period, usually 5 or 7 years using an accelerated depreciation method. Examples of personal property include carpeting, patient corridor handrails, telephone wiring, and special x-ray plumbing connections and vinyl floor coverings. Land improvements have a 15-year life and include items such as parking lots, sidewalks, roads, and fences. Nonresidential real estate is depreciated on a straight line basis over 39 years.
An example Assume an optometrist built an office for $1 million and placed the office in service on January 1, 2006. The optometrist is in the 33% tax bracket for federal tax purposes. (The effects of state taxes are ignored for this example.) After the cost segregation study, it is determined that the cost should be allocated as follows: 5% to land, 25% to personal property depreciated over 5 years, 10% to land improvements depreciated over 15 years and 60% to real property depreciated over 39 years. Using a 5% discount rate, the taxpayer would save approximately $45,000, which is a significant tax savings over the life of the building. Cost segregation became a useful tax planning technique after the Job Creation and Worker Assistance Act of 2002 and 2003. The tax act of 2002 provided an additional deduction of 30% of the purchase price of new property in the first year. To qualify for the 30% bonus depreciation the property must have been acquired after September 10, 2001 and generally must have been placed in service before January 1, 2005 and have a recovery period of 20 years or less.
Notice that the equipment must be “original use” equipment to qualify for 30% or 50% bonus depreciation. “Original use” means the first use to which the property is designated regardless of whether that use is by the current owner. To qualify for the 50% bonus depreciation, the property must generally have been placed in service after May 5, 2003 and before January 1, 2005 and meet the other requirements of 30% bonus depreciation. To see how the bonus depreciation laws affect cost segregation, our previous example is reworked using an “in service” date of January 1, 2004. Using the 50% bonus depreciation, the taxpayer would save approximately $52,000, an additional $7,000 savings. As discussed earlier, a taxpayer may have cost segregation studies prepared on existing real estate and recalculate depreciation in the previous year based on the study. A change in accounting method can be filed, and a deduction for depreciation that should have been taken based on the study can be deducted in 1 year. This deduction is accomplished by filing form 3115, and no amended tax returns are required. There are some potential drawbacks to a cost segregation study. Studies can at times be expensive, but normally the tax savings outweigh the cost of the study. Studies on an existing building tend to be more costly than those on newly constructed buildings. Another potential drawback is if the property is sold, the taxpayer may have to recognize more ordinary gains. The reason is that the profit on the sale of personal property is recognized as ordinary gains, as opposed to real property, which is recognized as capital gains and taxed at a lower rate. Although there are potential drawbacks in having a cost segregation study performed, the benefits usually prevail.
C
ost segregation can provide optometrists with significant tax savings and increased cash flow through the use of accelerated depreciation deductions on real estate. Generally, nonresidential real property must be depreciated straight line over 39 years. Using cost segregation, nonstructural components of buildings can be classified as personal property, accelerating depreciation deductions from 39 to 5 or 7 years. Cost segregation does not allow any
Cost segregation studies can help to increase cash flow and reduce tax liability. Here are the advantages and disadvantages of having a cost segregation study done for an OD practice. additional depreciation over the life of the building. Rather, it allows more depreciation in earlier years thus reducing tax liability and increasing cash flow. The court cases that follow present a background for cost segregation and show how it has been used to reduce tax liabilities. The court case Hospital Corp. of America v. Commissioner, 109 T.C. 21 (1997) was significant in defining current cost segregation. Hospital Corporation of America (HCA) constructed hospital facilities over several years. HCA classified some of the cost of constructing the hospital facilities as personal property and deducted them over 5 years. The Internal Revenue Service took the position that the items were structural components of the buildings and must be depreciated over the same period as the building. The court ruled in favor of HCA and stated that some items qualified as personal property. Several items in the HCA case that qualified for personal property included: ● Wiring related to television equipment ● Carpeting Kenneth E. Hicks, C.P.A. is Senior Partner in the firm of May & Company, LLP. Riley Nelson, C.P.A. is a member of the Professional Staff of May & Company, LLP. The firm consults with optometrists in 28 states, assisting with their tax planning and preparation, QuickBooks support, and business planning. May & Company was established in 1922 and has offices in Louisiana, Mississippi, and Alabama. They can be reached at 601-636-0096 or by e-mail at [email protected]. The opinions expressed are not necessarily those of the American Optometric Association.
Vinyl wall coverings Kitchen water piping Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975) is another major case that helped develop cost segregation. This case set out specific questions to ask to determine if property is considered personal property. The 6 factors the case established as qualifications for eligibility in the personal property category include: ● Can the property be moved and has it been moved? ● Is the property designed or constructed to remain permanently in place? ● Are there circumstances that show that the property may or will have to be moved? ● Is the property readily movable? ● How much damage will the property sustain when it is removed? ● How is the property affixed to land? A cost segregation study must be done before any property in question is classified as personal property. The study is conducted to see how components of a building can be broken down and classified. Before a study is performed, it is important to do a cost-benefit analysis to determine if the study will be beneficial to the taxpayer. Some of the factors in determining if a study should be performed include: ● The cost of the property ● The type of property ● If the property is new or an existing structure Generally, a cost-benefit analysis can be performed by the firm preparing the study, at no charge, to determine if the cost segregation study should be performed. ● ●
Performing the study Cost segregation studies can be performed on buildings under construction; existing buildings that have been renovated, remodeled, restored, or expanded; existing buildings being purchased; and any building purchased after 1986 in which cost segregation studies have not yet been performed. Cost segregation is performed by having an expert, such as a construction engineer, complete a study dividing building cost into 4 types of property: land, real property, land improvements, and personal property. ● Land is nondepreciable property. Land is the least advantageous property type because no cost recovery is allowed until the property is sold.
1529-1839/06/$ -see front matter © 2006 American Optometric Association. All rights reserved. doi:10.1016/j.optm.2006.01.022
194 ●
●
●
Practice Strategies Personal property has the most advantageous cost recovery period, usually 5 or 7 years using an accelerated depreciation method. Examples of personal property include carpeting, patient corridor handrails, telephone wiring, and special x-ray plumbing connections and vinyl floor coverings. Land improvements have a 15-year life and include items such as parking lots, sidewalks, roads, and fences. Nonresidential real estate is depreciated on a straight line basis over 39 years.
An example Assume an optometrist built an office for $1 million and placed the office in service on January 1, 2006. The optometrist is in the 33% tax bracket for federal tax purposes. (The effects of state taxes are ignored for this example.) After the cost segregation study, it is determined that the cost should be allocated as follows: 5% to land, 25% to personal property depreciated over 5 years, 10% to land improvements depreciated over 15 years and 60% to real property depreciated over 39 years. Using a 5% discount rate, the taxpayer would save approximately $45,000, which is a significant tax savings over the life of the building. Cost segregation became a useful tax planning technique after the Job Creation and Worker Assistance Act of 2002 and 2003. The tax act of 2002 provided an additional deduction of 30% of the purchase price of new property in the first year. To qualify for the 30% bonus depreciation the property must have been acquired after September 10, 2001 and generally must have been placed in service before January 1, 2005 and have a recovery period of 20 years or less.
Notice that the equipment must be “original use” equipment to qualify for 30% or 50% bonus depreciation. “Original use” means the first use to which the property is designated regardless of whether that use is by the current owner. To qualify for the 50% bonus depreciation, the property must generally have been placed in service after May 5, 2003 and before January 1, 2005 and meet the other requirements of 30% bonus depreciation. To see how the bonus depreciation laws affect cost segregation, our previous example is reworked using an “in service” date of January 1, 2004. Using the 50% bonus depreciation, the taxpayer would save approximately $52,000, an additional $7,000 savings. As discussed earlier, a taxpayer may have cost segregation studies prepared on existing real estate and recalculate depreciation in the previous year based on the study. A change in accounting method can be filed, and a deduction for depreciation that should have been taken based on the study can be deducted in 1 year. This deduction is accomplished by filing form 3115, and no amended tax returns are required. There are some potential drawbacks to a cost segregation study. Studies can at times be expensive, but normally the tax savings outweigh the cost of the study. Studies on an existing building tend to be more costly than those on newly constructed buildings. Another potential drawback is if the property is sold, the taxpayer may have to recognize more ordinary gains. The reason is that the profit on the sale of personal property is recognized as ordinary gains, as opposed to real property, which is recognized as capital gains and taxed at a lower rate. Although there are potential drawbacks in having a cost segregation study performed, the benefits usually prevail.