SECTION 754 AND COST SEGREGATION
January 07, 2016 by Charles Duncan
This memorandum provides a simplified, non-technical overview of the benefits of cost segregation and section 754 for real estate partnerships.
Partnerships: Cost Segregation and Section 754 Issues:
Section 754 in a Nutshell: When taxpayers form a partnership, the partnership generally has the same basis in a contributed asset as the partner whom contributed it. The partnership’s basis in the asset is called the “inside basis”. When a partnership interest changes hands, the basis of the new partner’s partnership interest will be equal to the purchase price. The partnership’s basis in its assets, however, will remain the same inside basis. Where a partnership’s assets have appreciated, a new partner will often be faced with deductions arising from the much lower, original cost basis of the partnership assets. Fortunately, Congress created an election that allows a new partner to effectively equalize the partnership’s inside basis and the new partner’s outside basis (the purchase price for the partnership interest). This is called a “section 754 election”. When dealing with improved real estate and partnership transactions, the most common result of a section 754 election is that the new partner, (and only the new partner), has newly placed in service depreciable property with a basis equal to the difference between the outside and inside basis in the asset. This results in larger depreciation deductions for the new partner than for the old partners
Three taxpayers form a partnership and they contribute a building to the partnership with a basis of $3 million. The partnership has an inside basis in the building of $3 million. After five years, one of the partnership interests is sold to a new partner. At this time, the building has a fair market value of $6 million. The partnership’s inside basis in the building remains $3 million. The partnership has a section 754 election in place. After computing the adjustments required by section 754, the new partner’s outside basis in the building is $2 million. The difference between the new partner’s outside basis and its allocable portion of the inside basis is treated as new depreciable property. In this example, that is $2 million less $1 million, or $1 million. This newly placed in service $1 million building asset is commonly called the section 754 step-up and generates additional depreciation deductions for the incoming partner.
Cost Segregation in a Nutshell:
When taxpayers acquire an improved property, the property is often composed of different components for tax purposes. Ordinarily, taxpayers allocate the purchase price between land and building. The land cannot be depreciated and the building is depreciated over 27.5 or 39 years. A cost segregation study allows taxpayers to identify portions of the building that qualify for shorter depreciation recovery periods such as depreciable land improvements and building components that are treated as tangible personal property for Federal income tax purposes. This opportunity is available not only for newly constructed or acquired buildings, but for almost all buildings placed in service since 1987. Even better, the tax laws allow taxpayers to catch-up on the missed, extra depreciation for all the years since it has been placed in service.
A taxpayer acquires a $5 million office building (purchase price net of land costs). The goal of cost segregation is to properly identify as much qualifying 5, 7, 15-year property as possible. The remaining nonqualifying property remains as 39-year building property. A reasonable allocation for an office building in a suburban setting is 6% – 8% as 5 year tangible personal property (carpeting, data cabling, etc…) and 8% – 12% as qualifying land improvements (paving, storm drainage, etc…). Assuming a tax rate of 40% and a discount rate of 6%, the estimated benefits of the cost segregation study are:
|Cumulative Net present Value||$109,000||–||$153,000|
|1st Year Increased cash Flow||$28,000||–||$39,000|
|1st 5-year Increased Cash Flow||$141,000||–||$195,000|
Estimated Cumulative Net Present value Of Tax Referral: Net Present Value is a method used in evaluating investments whereby the net present value of all cash outflows (such as the cost of the investment) and cash inflows (returns) is calculated using a given discount rate… In other words, it is a representation of the estimated benefit, over the life of a property, calculating the time value of the increased cash flow.
Where m is Present Value; n is Net Present Value; i is Discount Rate; and f is Amount Depreciated in a given year:
m = f * i * Tax Rate
n = m + n(previous)
As with the annual increased cash flow, the present value will net out to $0.00 over the life of the property. However, the cumulative net present value or NPV increases dramatically
Estimated Increased Cash Flow in Year 1: Increased cash flow is the increase in depreciation expense deductions, above that generated by straight line depreciation, created by front loading the property’s depreciation through a cost segregation study. Increased cash flow is calculated by multiplying the increased amount depreciated by the property owner’s tax rate
Where g is Increased Cash Flow; and f is Amount Depreciated in a given year:
g = f * Tax Rate
Estimated Increased Cash Flow in Years 1-5: This is calculated in the same manner as the Increased Cash Flow in Year 1 but is a reflection of the first 5 years following the implementation of a cost segregation study
Cost Segregation and Section 754 Step-ups
One downside of cost segregation is that it frontloads depreciation during the early years after a building has been placed in service. For the first six to sixteen years after a cost segregated building has been placed in service, the building will generate increased annual depreciation deductions. In later years, however, the building will generate smaller annual depreciation deductions than if it had not been cost segregated. Due to the cash benefit of the catch-up depreciation in the current year, most taxpayers will still perform cost segregation studies on buildings in their later years in spite of the decreased future depreciation deductions. For older buildings owned by partnerships with one or more section 754 step-ups reflected on the tax depreciation schedule, the incentive to have a cost segregation study may increase greatly not just in the early years, but also in later years.
This increased benefit is due to all partners receiving the cash benefit for the catch-up depreciation and the partners with section 754 step-ups receiving even more catch-up depreciation and possibly increased future depreciation deductions. Where no cost segregation study has been performed in the past (and depending on how the partnership agreement treats partnership interest dispositions), the availability of catch-up depreciation for the inside basis and greater depreciation deductions from the section 754 step-ups may make partnership interests more attractive to investors. Combining section 754 step-ups with cost segregation
- I.R.C. § 723
- Treas. Reg. § 1.742-1.
- I.R.C. § 754.
- For a general overview of cost segregation, see the IRS Cost Segregation Audit Techniques Guide available at: http://www.irs.gov/Businesses/Cost Segregation-Audit-Techniques-Guide—Chapter-1—Introduction
- John Downes & Jordan Elliot Goodman, eds.
Dictionary of Finance and investment Terms. 6th Edition.
New York: Barron’s, 2003.