What is Cost Segregation?
Cost segregation is a highly beneficial and widely accepted tax compliance strategy utilized by commercial real estate owners and tenants to accelerate depreciation deductions, defer tax, and improve cash flow. Once used only by big-4 type accounting firms and the nation’s largest real estate owners, this practice has now become routine for commercial property owners of almost every size.
Cost segregation is considered one of the most effective tax strategies for real estate owners and investors and is one of the top niche services for accounting firms. You may be leaving serious tax benefits on the table by not using it. It’s not just for newly constructed or newly acquired assets and it can dramatically increase your cash flow.
When Should a Cost Segregation Study be Performed?
There are several situations where a cost segregation study should be performed. A cost segregation study should be performed immediately after construction or acquisition or following major capital improvements (including leasehold improvements). The study can also be performed after a change in ownership, including inherited property and change in partnership interest. And finally, a cost segregation study can be useful for buildings already in service. In this situation, a Look-back study would be performed.
The IRS permits taxpayers to use a cost segregation study to adjust depreciation on properties placed in service as far back as January 1, 1987. Many property owners and tax advisors share a common misconception that once the three-year statute to amend has expired, the taxpayer can no longer make a change. Fortunately, this is not the case. Upon completion of the study, the taxpayer is allowed to make an adjustment under IRC §481(a) to catch up on depreciation. The catch up, which is taken in a single year, is equal to the difference between what was depreciated and what could have been depreciated if a cost segregation study was performed on day one.
Expectedly, these benefits can be quite substantial. As an added bonus, the change can be made without filing an amended return. The taxpayer simply files Form 3115, Application for Change in Accounting Method.
Covid and the Hospitality Industry
The travel and hotel industries were especially hard hit during the pandemic. In fact, the hit on the travel industry was nine times worse in 2020 than it was after the 9/11 terrorist attacks. A November 2020 survey by the American Hotel & Lodging Association found that 71% of U.S. hoteliers could not survive another six months without further government assistance. Although many hotels are in danger of losing their properties to foreclosure, their property tax payment obligations have not been suspended. Hotels are generally taxed heavily on their real estate because of their construction costs and high ongoing revenue potential.
Why is Cost Segregation Beneficial for Hotels?
Hotels contain assets and amenities that make cost segregation highly effective. Resort hotels in destinations such as Colorado and Wyoming may own or be adjacent to areas for skiing and include the accompanying ski lifts and other ancillary services such as shopping centers, ice rinks, restaurants, and health spas. Other destinations such as Florida and California have properties that include golf courses and other exterior amenities such as elaborate pool areas. Interior features may include multiple restaurants, bars, retail stores, indoor pools, and game and recreation areas.
The guestrooms in hotels and motels generally have glued on finishes, millwork of varying complexity, electrical and data connections for computers, telephones, and televisions. Some include wet bars and other amenities. Many extended stay and all-suites hotels now also have fully appointed kitchens in their guest rooms. Common area amenities may include guest and commercial laundry facilities, and fitness rooms. The recovery period is generally 5 years for the personal property associated with hospitality. 15-year land improvement property includes large parking areas, extensive landscaping, exterior decorative and site lighting, swimming pools, and outdoor gathering areas.
Accelerating the depreciation on 10% – 40% of the capitalized costs is typical, depending on the type of facility, number of amenities, quality of the finishes, and extent of the site improvements.
Hotel Cost Segregation Case Study
The subject property is a newly constructed, full-service hotel, with 122 units, placed-in-service in early 2018 for $35,200,000. The building is 83,000 square feet and has four stories. The construction cost includes all furniture, fixtures, and equipment.
This hotel has guest-room kitchens as well as a common area kitchen and full-service bar. There is an onsite commercial laundry as well as a guest laundry. In addition, guests have access to a small market pantry, business center, and fitness center. The building is a steel and wood framed structure with hard plank siding, cement plaster, and stone veneer exterior walls.
The site is improved with a pool, fencing, several guest-seating areas with fireplaces, barbeque grills, ample parking, and moderate landscaping.
The Source Advisors Cost Segregation engineers were engaged to analyze the construction cost. Contractor costs, sub-contractor costs, record ledgers, vendor invoices, and architectural plans were analyzed to properly allocate construction costs between, building property, land improvements and personal property. Indirect costs were allocated on a pro rata basis. A thorough inspection of the property was conducted. Key property personnel were also interviewed. A detailed report was delivered, identifying and documenting all of the components that qualify for a shorter tax life.
Source Advisors reclassified 15% or $5,300,000 as 15-year land improvements and 23% or $8,080,700 as 5-year tangible personal property. This leans towards the high end of the expected range and was due to the guest room kitchens, interior guest amenities, and extensive land improvements. In addition, although it was placed-in-service in early 2018, the majority of construction occurred prior to September 28, 2017. Due to the binding contract rules, it qualifies for 40% bonus depreciation under the PATH Act and not 100% bonus under the Tax Cuts and Jobs Act.
The Source Advisors Approach
Our approach to cost segregation follows these values. At Source Advisors, we don’t train our team on your dime. We only hire heavily experienced cost segregation specialists. We believe experience is critical to maximizing the benefits of cost segregation, and the majority of our team has spent between 10 and 20+ years managing cost segregation projects. Even our least experienced member has conducted more studies than many who manage projects at large firms.
We have a specialized in-house dedicated cost segregation team. Our team is composed of architects, professional engineers, CPAs, MBAs and LEED cost segregation specialists dedicated solely to cost segregation. Our management team is involved in every project we’re engaged to perform and often conduct the site visits themselves. And, with rare exceptions, we always conduct a site visit. The IRS expects it, and we believe it is the best way to accurately assess a property.