New Tax Law - The Tax Cut and Jobs Act, 12/22/2017 Good News - 100% Bonus Depreciation for 20 years-life segregated property classfication can be allowed for the property placed after September 27, 2017.
Example - Actual Case I Performed
14-Story Office Building
Purchase Price - $37,170,000
Improvements Basis (for Cost Segregation) except Land - $30,985,316
After Cost Segregation
5-year life class - $5,888,901
(19.01% of the improvements basis)
7-year life class - $154,563 (0.50%)
15-year life class - $324,665 (1.05%)
Total eligible for 100% Bonus Depreciation at the first year (5, 7, 15 years class combined) under the new tax law:
If under the old tax law prior to 09/27/2017, apply the double-declining balance method, the first year (5, 7, 15 years class combined), the depreciation will be:
That is the increase of depreciation benefit of $3,935,206 at the first year.
Assuming a tax bracket of 37% for married filing jointly over $600,000, additional tax savings will be $1,456,026 depending on the individual or entity's tax situation.
Take a huge tax deduction by doing the Cost Segregation. Under the alternative depreciation system, as modified by the Act, the recovery periods for nonresidential depreciable real property, residential depreciable real property and qualified improvements are 40 years, 30 years and 20 years, respectively. The Act extends and modifies the additional first-year depreciation deduction for qualified depreciable personal property by increasing the 50% allowance to 100% for property placed in service after September 27, 2017, and before 2023. After 2022, the bonus depreciation percentage is phased-down to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026. The bill removes the requirement in current law that the original use of qualified property must commence with the taxpayer. Thus, immediate expensing applies to purchases of used as well as new items.
What is Cost Segregation?
Something called cost segregation may help owners of commercial real estate save significantly on their federal income taxes.
The primary goal of a cost segregation study is to identify all construction-related costs that qualify for accelerated income tax depreciation. Small or large, your business can save money with a cost segregation study, typically many times the amount you invest. The Benefits of Cost Segregation We perform a detailed analysis of your commercial property for the purpose of identifying all of the construction related expenses that can be depreciated over 5, 7 and 15 years. The result of our study is the accelerated depreciation of these deductions, reducing your tax liability and increasing your cash flow.
The Benefits of Cost Segregation (applicable to prior to 09/27/2017)
Cost Segregation is a tax planning tool that determines how quickly an owner should be depreciating the property on his income taxes — five years, seven years, 15 years, 27.5 years or 39 years. The Internal Revenue Service allows owners of commercial properties to accelerate depreciation on their real estate, which will result in reducing the property owner’s taxable income levels. A cost segregation study is an in-depth analysis of the costs incurred to build, acquire or renovate a real estate holding.
Hotel/Motel, Gas Station/ Car Wash, Industrial/ Warehouse Building, Apartment, Office Building, Grocery Store, Restaurant, Retail, Nursing Homes, Golf Course, Auto Related, Leased Tenant Improvements.
Any commercial/investment real property placed into service since January 1st, 1987 may benefit from a Cost Segregation Study (CSS):
Critical timing is when the property was placed into service by the current owner / taxpayer, not when the building was originally constructed.
•New construction, including renovation, remodeling, restoration, or expansion to an existing building
•Property acquired via purchase
•Property acquired via inheritance
•Property which received step-up in basis
•Major leasehold improvements
Certain types of buildings benefit from a CSS more than others. Those are the types of buildings that tend to contain:
•More specialty plumbing, electrical, HVAC system, etc.
•Higher amount and quality of personal property
•Extensive land improvements
Classification from real property to land improvements and personal property.
The building system value, referred to as the unit of property, or UOP, is the reference point from which capitalization decisions are applied. Under the new UOP definition, expenditures relating to each building system must be evaluated as repairs or improvements only with respect to that particular system and not with respect to the entire building.
Taking advantage of cost segregation studies to provide significant tax benefits for their businesses by accelerating the depreciation on qualified fixed assets.
By depreciating the personal property costs of such assets over five or seven years (and land improvements over 15 years instead of the typical 39-year recovery period for general building property), the additional deductions can be used to offset taxable income. This accelerated depreciation, in turn, provides additional cash flow.
Now, due to the favorable tax law changes in the IRS tangible property regulations, those potential savings are more valuable than ever to your company’s financial future. These new IRS tangible repair regulations give taxpayers a second reason to engage in a cost segregation study: the future. Rather than focusing on the benefit of current or previous year tax deferral as in past studies, cost segregation studies have now become a multi-use tool now that can help ensure that taxpayers are complying with the final repair regulations.
Each building and its structural components is a separate unit-of-property. In determining whether an expenditure is an improvement, the taxpayer must consider the effect of the expenditure on the building structure itself and on certain specifically defined components of the building (the "building systems"). Each of the following "building systems" is defined as a separate unit-of-property:
The ultimate result of the regulations is to reduce the size of the unit-of-property which increases the likelihood that an expenditure will need to be capitalized as an improvement. For example, if a taxpayer had an expenditure related to its building roof, the unit-of-property to use in determining if it is a capitalized improvement or a deductible repair is the building since the roof is not included in one of the separate building systems. For an expenditure to repair several of the building's rooftop air conditioner units, however, the appropriate unit-of-property to use in determining if it is a capitalized improvement or a deductible repair is the HVAC system (a smaller unit-of-property than the building) since the HVAC system is one of the specifically defined building systems.
Most taxpayers have previously treated the entire building as the unit-of-property. With the addition of these new regulations, most taxpayers that own buildings will need to make an accounting method change to adopt the new definition of unit-of-property as it relates to buildings.
Under the new tax law (effective as of 01/01/2018) non-structural assets installed to the interior of a building after the building is originally placed in service are considered Qualified Improvement Property, or QIP. The intent of the law these assets were supposed to be considered bonus depreciation eligible.
In most cases, renovation project improvements expands not only interior improvements, but also other building component systems such as exterior facades, HVAC systems, Elevators, Escalators, load bearing walls, etc. A cost segregation study may be necessary to break out the assets that are not QIP. Without an analysis to break apart the QIP from the remaining assets a taxpayer will not be able to maximize the bonus eligible property.
Additionally if a renovation is combined with an expansion, a study will be required to separate the assets included in the expansion from the assets in the original space. When a taxpayer completes a renovation a discussion should be had with a trusted professional to determine if a study is necessary to determine the amount of QIP.
The Tangible Property Regulations (also known as Repair Regulations) are the largest change to US Tax Law in 30 years and affect every building owner in America. The final regulations provide a general framework for distinguishing capital expenditures from supplies, repairs, maintenance, and other deductible business expenses. Building owners and their tax professionals now have strict guidelines as to what stays on a fixed asset schedule and what must come off. Not only must every building owner in America follow and apply these regulations to their accounting practices, but there may be a financial upside to doing so. Our Cost Segregation Study reviews the regulations to assist with compliance along with the financial benefit.
We provides the necessary calculations for business owners to apply the Tangible Property Regulations; this is coordinated with your tax professional.
When a taxpayer makes an improvement to a unit of property, the project often includes demolishing or removing a portion of the property. A write-down can be taken on the items removed from the building, but this must be done in the year the items were removed. We provide the calculation for Partial Asset Dispositions when business owners make improvements to their buildings.
A taxpayer who has made the Partial Asset Disposition election can also deduct the costs of a project associated with removing and disposing components of the building. This write-down would be done instead of capitalizing these costs with the improvement costs, but it also must be done in the year of the disposition deduction. We provide the calculation for Removal and Disposal Cost which occurs when improvements are made to buildings.
Have you replaced items in your building in the past? Replaced a roof or parts of a roof? Replaced HVAC equipment or completed entire renovation(s) to your building? The new Repair Regulations state that there be no “ghost assets” on your fixed asset schedule. Our Cost Segregation Study will find duplicate items that are currently being depreciated and identify them, along with their value, for a write-down. We provide an analysis for the calculations to be applied for historical capital assets that may now be reversed to expense.
The IRS has formally approved the ability to dispose of the remaining cost basis of assets previously retired, replaced, or demolished. This is outlined in the Tangible Property Regulations (IRC §1.168 (i)-8) and can be a tremendous vehicle for tax savings.
Our process includes a review of the existing depreciation schedules, demolition drawings, and other pertinent information. The team also assesses the scope of recently completed capital work to determine the potential for disposition. When this review identifies assets ripe for disposition—but does not warrant a Standard Cost Segregation Study—we suggest our Partial Asset Disposition (PAD) Analysis.
As defined in the Tangible Property Regulations, a PAD Analysis may be conducted in one of three ways:
The outcome of our PAD Analysis is a report that quantifies and presents the value of dispositions, outlines when the assets were placed into and taken out of service, and describes the asset(s) in question. With this information, the client may determine the remaining depreciable basis to support a Partial Asset Disposition election.
A PAD Analysis can also be used to update existing Unit of Property values.
Tangible Property Repair (TPR) Regulations
Taxpayers can realize significant benefits from the Tangible Property Repair (TPR) regulations by identifying building components that have been replaced or demolished in current or prior years and claiming retirement loss deductions. However, it is often difficult to determine the tax basis of each component without a cost segregation study. While the IRS agrees that a cost segregation study can be used for this purpose, they also allow the “PPI discounting approach” that our calculator utilizes. For more information on the IRS rules related to the PPI discounting approach, see T.D. 9689 Guidance Regarding Dispositions of Tangible Depreciable Property.
Purchase Price Allocation (PPAs) are required for every controlling transaction wherein the acquirer complies with Generally Accepted Accounting Principles (“GAAP”), with varying complexity based on the entities and/or assets involved in the transaction.
If the transaction does not meet the definition of a business, the transaction is accounted for as an asset acquisition.
► Allocate the cost of the acquisition to individual asset components acquired and liabilities assumed on a relative fair value basis as discussed in ASC 805-50-30-3
► Cost of the acquisition = purchase price plus direct acquisition costs
► Goodwill and bargain purchase gains are not recognized in asset acquisitions.
The buyer of an institutional multi-tenant office building or regional mall is not only purchasing the underlying land and the bricks & mortar, it is also acquiring all lease contracts in place, along with the various implications driven by those contracts.
As income-generating properties, the appropriate methodology varies to best reflect market participant application. As such, the property is typically valued on an as-vacant basis via the cost and income approaches. A cost approach is first modeled, which appropriately values the land and improvements with no consideration of leases in place.
The cost approach is supported by a ‘go-dark’ income analysis, which capitalizes the future income stream associated with the property, but under the hypothetical scenario of complete vacancy, so as to exclude any contribution from the leases in place (which are valued separately). The sales comparison approach is also employed, but primarily as
support to the Fair Value conclusion of the individual tangible and intangible assets
in aggregate. This is due to the leased fee nature of similar investment-grade
transactions, in which all real property assets are conveyed in one bundle or rights.
Use sales comparison approach, abstraction method or residual land capitalization approach.
-- Cost Approach: An informed purchaser would not pay more for a property than the cost of producing a substitute property with equal utility (MVS or construction comparables)
-- Income Approach, "Go Dark" Analysis
Utilize a discounted cash flow (DCF) model based on the assumption that the building is initially vacant and leased up over a period of time to stabilization
-- Land value and site improvement value are deducted from the value determined through the DCF to arrive at the building value
-- Reconcile the Income Approach and Cost Approach to determine a final value estimate for the building
-- Methodology: Cost Approach
Estimate the RCN for each site improvement and FF&E component via industry survey data or cost comparables and adjust the cost for depreciation (physical deterioration, functional and external obsolescence)
Physical deterioration is generally calculated using the age/life method (effective age/economic life)
-- Methodology: Cost Approach
Represents the value associated with "cost avoidance" of acquiring an in-place lease. Part of the market cost to execute a similar lease are costs related to tenant improvement allowances given as an inducement to rent the space. Other cost include leasing commission and legal/marketing expenses.
The values of tenant improvements and leasing commissions are estimated to be the market tenant improvement allowance and the market leasing commission, respectively, multiplied by the percentage of the original lease term remaining. )
Above/ below market lease(s)
Methodology: Income Approach
-- Discount the difference between the contract rent and market rent over the remaining term of each tenant's lease
-- Significant judgment exists with regard to the treatment of renewal options. Consider the following when assessing renewal options:
- Is the renewal within the control of the tenant?
- Does the renewal provide economic benefit to the tenant?
Above/ below market ground lease(s)
Legal/ marketing fees
Leases in-place (forgone rent)
Methodology: Income Approach
-- Represents the value related to the economic benefit for acquiring the property with in-place leases as opposed to a vacant property
-- Measured as the income (rent and expense reimbursement revenue) over the estimated amount of time that it would take to lease the space to stabilized occupancy.
-- The value of the Lease In-Place should not exceed the value of the remaining cash payments under the lease.
Methodology: Income Approach
-- Represents the PV of the NOI difference expected if a tenant renews their lease versus if they vacate and the owner is required to find a new tenant.
-- Tenant relationships are uncommon.
-- Estimated NOI difference is calculated as the sum of the following items multiplied by the renewal probability:
Monthly market rent expense recoveries at the end of the current lease term for the estimated months vacant before a new tenant is in place.
Difference in TI allowance required and leasing commissions paid at the end of the current lease term for a new tenant versus a renewal tenant
-- The expected NOI value is then discounted from the end of the current lease term to the acquisition date to estimate the current value of the tenant relationship.
Unamortized leasing commissions
Favorable purchase contracts
Above/ below market debt
PPA accounting guidance requires that notes payable and other long-term debt be assigned amounts “at present values of amounts to be paid, determined at appropriate current interest rates.” Therefore, if a mortgage is assumed in the acquisition of a property, there may be an intangible asset to the extent that the assumed mortgage features a below-market coupon. Likewise, assumed mortgage featuring above-market coupons represent an assumed liability to the buyer.
-- Methodology: Income Approach
- If property-level debt was assumed as part of the transaction, the debt should be fair valued in accordance with specific mortgage terms in relation to current market terms as of the acquisition date to determine if a favorable/ unfavorable condition exists.
Goodwill shall be recognized as of the acquisition date and measured as the excess of (1) over (b).
(a) The aggregate of the following:
-- The consideration transferred measured in accordance with ASC 805-30-30-1, which generally requires acquisition-date fair value.
-- The fair value of any non-controlling interest in the acquire
-- In a business combination achieved in stages, the acquisition-date fair value of the acquirer's previously held equity interest in the acquiree.
(b) The of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with ASC 805.
-- Bargain purchases occur if the acquisition-date amounts of the identifiable net assets acquired, excluding goodwill, exceed the sum of
(1) the value of consideration transferred
(2) the value of any non-controlling interest in the acquiree; and
(3) the fair value of any previously held equity interest in the acquiree
-- A bargain purchase should be recognized in earnings (profit or loss) and attributed to the acquirer
Replacement Cost Valuation method (opposed to the conventional cost approach) is used to determine the cost to rebuild properties in the case it gets completely destroyed by a fire, hurricane or other disaster.
The Replacement Cost (in conventional appraisal theory) is defined as
“The estimated cost to construct, at current prices as of the effective appraisal date, a building with utility equivalent to the building being appraised, using modern materials and current standards, design, and layout”.
However, the definition of insurance replacement value is different:
"The cost of replacement of all improvements to a property which could conceivably be destroyed."
In summary, Replacement Cost is the actual cost to replace an item or structure at its pre-loss condition.
Relevant cases for Replacement Cost:
1. For insurance coverage purposes, the insurable value of the property is the replacement cost new of the building improvements only, with no land value, depreciation or site improvements. Developer's profit is not considered.
2. HOA requirements - Homeowners' Association for condominium, townhouses, planned unit development must be re-evaluated within certain interval period.
3. Value of the improvements for certain renovations - Many jurisdictions state that new renovation improvements to a total property cannot be made beyond 50% of the actual value of the improvements.
1. Obtain a complete working drawings or perform the inspection of the property taking measurements, photos and notes on the major components that make up the property.
2. Utilize the professional commonly recognized software that calculates the building cost based on condition, quality, and zip code.
3. In addition to the building cost estimates, other site improvements including parking and landscaping are added if they are required.
4. If necessary, tenant-interior improvements that is permanently fixed to the building (specific to the special use such as the lodging, medical, office) is estimated.
5. Once all calculations and findings are compiled, the professional replacement cost appraisal report can be presented.
he Replacement Cost does not count any land value. The purpose of replacement cost is for the use for insurance coverage. The replacement cost is not same as the market value.
When the Cost Approach is utilized to arrive the market value indication, the concept of accrued depreciation (not accounting concept, rather value loss) must be analyzed.
Accrued depreciation is then subtracted from the cost new estimate to quantify the contributory value of the subject improvements.
Accrued depreciation is defined as:
“the difference between an improvement’s reproduction or replacement cost and it’s market value of the date of appraisal”
Accrued depreciation can be caused from physical, functional or economic sources. Physical depreciation is basically the diminished utility of the physical components of the structure. In other words, the older the improvements, the less remaining life the improvements have. Functional obsolescence is a loss in value due to a poor design, over-improvement or outdated structural components. Functional obsolescence can be either curable or incurable. An item of depreciation is considered to be curable if it is economically feasible to correct as of the date of appraisal. If the item is not economically feasible to correct, it is considered to be incurable depreciation. Economic obsolescence is a loss in value to the subject’s improvements that are caused by factors outside of the subject’s boundaries.
The scope of work is to appraise the improvements "as-is" without the underlying land value.
Flood Value - includes foundation
Casualty Value (Fire, Wind) - excludes foundation and about 15% of plumbing and electric.
In most cases, the following are not part of the scope of work: Demolition, Debris Removal, Depreciation
- The application of depreciation is an insurance internal decision applied by the insurance carrier in a payout scenario (Actual Cash Value vs. Replacement Cost Value).
- The difference between new construction and reconstruction is approximately 15% of an industry standard.
- "Up to code" is the replacement of the structure under consideration of current building codes in the local jurisdiction.
- The scope does not consider any market forces of Highest and Best Use.
- Conventional cost approach deducts depreciation and includes the site.
- An insurance appraisal requests the reconstruction value of the improvements as-is with like-kind material, no consideration of depreciation and the exclusion of the underlying land value.