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The cost segment is a timely strategy for commercial property owners who filed tax extensions this year

As the economy struggles to improve, business and investment property owners are looking for all the tools to improve their bottom line, especially as this year’s extension tax filing deadline approaches. Individuals and businesses considering a large tax liability as of Sept. 15 or Oct. 15 are sure to celebrate any business strategy that provides a tax benefit and increases cash flow. Cost segregation does just that. It’s no wonder cost segregation is very popular this time of year with investment property owners and business-use property owners.

What is cost segregation? As most investment property owners know, in general, buildings can depreciate over a period of 27.5 years or 39 years. However, according to the Internal Revenue Code (IRC), certain categories of fixed assets can depreciate more quickly, over five, seven or 15 years. Identifying and reclassifying these eligible assets can accelerate some of the building’s tax depreciation and create a reduced tax liability. A cost segregation study, or “cost segregation,” is the engineering and tax analysis that identifies and segregates these eligible assets, assesses their value, and determines the resulting asset classes and the corresponding accelerated depreciation. The bottom line? Cost segregation saves homeowners money by justifying higher initial tax deductions and, in turn, lowering their taxable income and therefore reducing their tax payments.

What assets qualify for accelerated depreciation? Eligible assets are systems, accessories, or related items that are unnecessary for the operation of the building itself or are temporary structures. They include items such as decorative lighting or trim, certain floor or wall coverings, or redundant HVAC systems. Using the guidance set forth in the IRS Guide to Auditing Techniques, experts in the areas of taxation and engineering separate or segregate these elements. This process provides the maximum tax benefits to homeowners with facilities built or purchased within the last seven years, as well as those with major construction in progress or recently renovated or expanded facilities.

For example, a real estate investor with 30 apartment buildings recently considered conducting cost segregation studies on several of his properties. Some buildings were luxurious garden-style apartment complexes, while others were urban-style apartment buildings. Some had been recently purchased, while others had been withheld for many years. After answering some basic questions, he decided to proceed with a cost segregation study in four garden-style complexes that he had owned for five years. The reasons for this were twofold: First, unlike urban-style apartment buildings, garden-style apartments had more assets that could be accelerated from 27.5 years to 15- and 5-year properties. The second was that older properties generate an update setting (more on this below). By working with their CPA and Madison SPECS, the investor was able to identify the buildings that would generate the highest depreciation and conducted cost segregation studies on them. The studies resulted in a combined tax benefit of more than $ 2.2 million.

In new construction cases, it is best to incorporate cost segregation as soon as possible to save money on federal, and possibly state and local tax returns. For existing properties, underestimated depreciation can be recovered for past construction, purchases, expansions, renovations, and qualified leasehold improvements. Owners can recoup lost depreciation with a simple change in accounting method. Amended tax returns are not required; instead, “recovery” depreciation can be taken in one year by filing IRS Federal Form 3115 (Change in Accounting Method, with IRS Consent Automatically Granted). Please note that IRS Form 3115 was recently updated in December 2009.

As tax deadlines approach, cost segregation studies may be among the most valuable tax strategies available to commercial and investment real estate owners. To download the free Madison SPECS publication “All About Cost Segregation,” visit http://www.madisonspecs.com.

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