Written by Joel Grushkin:
If you’ve been using cost-segregation studies to accelerate depreciation of your hospitality property, you’ve likely cut your taxes considerably. But could you save even more?
Just like hotels, not all cost-segregation studies are created equal. So what can you do to maximize the savings from cost segregation?
First, you will need to understand what a cost-segregation study is and how it can reduce your taxes. If no cost-segregation study is conducted, the hotel you own will be depreciated over 39 years, using the straight-line depreciation method.
When a cost-segregation study is performed correctly, a building instead is considered as a collection of sinks, doors, toilets, shower stalls, wood trim, electrical switches, countertops, pipes and hundreds — or even thousands — of other components.
Land improvements, which include landscaping, drainage systems, paving, and curbing, can be depreciated over 15 years. Personal property, such as finish carpentry, emergency power generators, cabinets, and even certain heating, ventilation, and air conditioning units, can be depreciated in five or seven years.
By segregating these costs, typically 15 percent to 35 percent of the purchase price of a hotel property can be reallocated for depreciation over shorter periods of 5,7, or 15 years, respectively. If you spend $10 million on a building, for example, it’s likely that $1.5 million to $3.5 million can be reallocated to “shorter lives” and depreciated more quickly.
While some firms have been limiting their so-called cost segregation studies to breaking out the obvious 5-year, and 15-year property, they have left everything else in one line item called 39-year property or structure. This type of study, referred to as a residual study, has the lowest level of acceptability with the IRS. Although this may not, as of yet caused problems for clients, it was never optimal. As we enter the 2014 tax filing season many owners will learn why. Effective January 1, 2014, the IRS put in place new regulations focused on how hotel owners account for “Repairs and Maintenance”. In essence, the IRS is forcing capitalization of more items. The new regulations, described in nearly 300 pages of guidelines, including 120 examples/tests, require that certain procedures be followed to determine whether you can expense repairs and maintenance items in the current year or whether you have to capitalize and depreciate them.
Although this is cumbersome and time consuming, there are some shortcuts and huge benefits. This is where a “less than fully engineered and detailed” cost segregation study becomes problematic and why an owner that hasn’t had such cost segregation studies completed on their properties may want to seek counsel from a more experienced and knowledgeable cost segregation firm. Under the new regulations, when you renovate/remodel a property, either in whole or in part, any items removed and disposed f during renovation that are not fully depreciated, are now allowed to be written off in the current year.
What might this look like? I decide to renovate 10 bathrooms in my hotel. Nearly everything in a bathroom including tubs, showers, toilets, sinks, tile, vanities, even drywall has a 39-year life. If I have owned my hotel for 10 years, I have only depreciated about 25% of the value of everything in those bathrooms. If I dispose of everything I mentioned I could take a write-off for 75% of the value at the time I purchased my hotel. Here is the problem: If I haven’t had a fully-engineered cost segregation study done on my hotel, or even more problematic, if the firm that did my study didn’t break apart all of the 39 year property, I have no way of knowing the values of each individual item. If I can’t support my numbers, I cannot take the write-off. If I did have a detailed study done, I have the data to offset a significant amount of those renovation costs.
To ensure the maximum benefits realized from a cost segregation study, such a study would not only break out all personal /specialty property, but define and value each system in the building (typically between 5-9), each sub-system, each component, all the way down to unit pricing levels. That means that when I renovate those bathrooms, and I find some water damage and have to replace dry wall, I will have the data to calculate what that drywall was worth when I purchased the property and I can now take the write-off. It may not sound like a lot on one bathroom…..but when you add up the total renovation the number gets very significant very quickly. This is particularly important in for your 2014 tax return.
- “Look-Back Study” – If you have not had your property studied, the IRS allows a “Look-Back Study” which re-computes all of your depreciation from the date of acquisition, allocating all elements to 5, 7, 15, and 39 years, respectively and “catches you up” with what you could have depreciated, had you had cost segregation done at the time of purchase. The difference between what you could have taken and what you have already used on straight-line, can be applied all at once on your next tax return without requiring you to amend your prior tax returns.
- “Last Bite of the Apple” – If you have completed renovations in the past several years and disposed of elements removed from your property, the IRS is allowing you the opportunity to have a “Disposition Study” completed to re-create the values of items disposed of and take write-offs of the un-depreciated values. However, if you wish to take advantage of this opportunity, it must be completed and filed with your 2014 Tax Return. If you don’t file this as part of your 2014 return this is lost forever.
Joel Grushkin is Regional Director of Cost Segregation Initiatives, a firm specializing in
Cost Segregation and deal strategy for commercial real estate owners.
firstname.lastname@example.org Tel: 858-922-1037