Increase Clients’ Cash Flow
Cost segregation can help your customers and grow your business
By Terry Judge CEO CORE Solutions Group LLC
In today’s credit markets, it is necessary to find ways to improve property-owners’ balance sheets to help them qualify for financing. Cost segregation is a tool that can improve many investors’ liquidity.
Most commercial real estate professionals have heard of cost segregation, but not everyone understands its value and immediate cash impact. These benefits can translate into better prepared financing applications. An Internal Revenue Service (IRS)-supported tax strategy, cost segregation can open up hundreds of thousands of dollars in cash flow by reclassifying qualified costs from real property to tangible personal property. These costs then qualify for accelerated depreciation in the form of larger write-offs against federal income tax.
Commercial mortgage brokers can work with certified public accountants (CPAs) and specialized third-party engineering firms to offer this option to their clients. Brokers who understand the process and recommend cost segregation studies to their clients can increase their business.
How it works
Cost segregation essentially reclassifies a portion of the cost basis into personal property. This includes plumbing, mechanical and electrical systems, along with many other items from millwork to carpeting.
The cost basis eligible for reclassification typically falls between 15 percent and 40 percent. This allows for faster depreciation schedules, therefore decreasing immediate tax liability. Depreciation schedules can go from 39 years down to 15-, seven- and even five-year depreciation lives. This opens up cash flow and improves balance sheets.
In 2004, the IRS released a techniques guide that articulates the stringent steps necessary to complete a cost-segregation study successfully. The guide lists several acceptable methods, including a “detailed engineering approach.”
This is where engineering firms come into play. When choosing an engineering firm with which to work, make sure it provides audit defense at no cost. Also compare sample reports from different firms to determine the most sufficient reporting.
Some CPA firms will not outsource to engineering firms, and some engineering firms don’t use a CPA or comparable official on behalf of the client — stay away from both. Teamwork is needed to maximize the benefits for your clients and to protect their best interests.
When to do it
It is prudent for all commercial property-owners to see if they qualify for cost segregation. The best time to implement the strategy is immediately after a transaction has closed. This helps maximize tax deductions and cash flow.
A special caveat, however, allows the study to look back to 1987 for any missed deductions and bring them to the current year. For instance, if your client purchased a building in 1995, engineers can document all costs that would have qualified as if a study were done at the time of purchase. So, if there were $100,000 of qualified costs from 1995 to 2008, your clients would realize that depreciation right away, thus receiving $100,000 in immediate additional cash flow.
Cost-segregation studies can especially help property-owners who are purchasing more property. Many applicants looking to buy more property are turned down because of liquidity issues. Studies could be performed on their current properties to improve their balance sheets and to provide more cash on hand, thus improving their chance of obtaining financing.
“The best time to implement [a cost-segregation] strategy is immediately after a transaction has closed.”
The same goes for refinancing clients. If they need to access equity or get better terms on their loan, it behooves them to improve their balance sheet. For many properties, the study takes four to six weeks to complete.
How clients qualify
There are a few requirements to qualify a property. The most important is that the owning entity must be paying federal income taxes. For the study to be cost-effective, most firms will require the cost basis (excluding land value) to be greater than $500,000, and many will only accept at least $1 million. In accordance with IRS court rulings, the property must be placed in service after Jan.1, 1987. Existing properties, new construction, leaseholds, renovation/remodeling or abandoned properties slated for demolition are eligible. Property types vary widely, and it is best to consulta professional if you’re not sure if a property will qualify. Owning property is not a requirement to qualify for cost segregation. Leaseholders also can qualify if they’ve spent more than $350,000on renovation costs. Property-owners are strongly advised to keep the property for at least 12 to 24 months after the study to realize benefits and to avoid recapture.
Why recommend it
Apart from increasing your clients’ cash flow, there are seven reasons you should consider recommending cost-segregation studies:
- It improves the chances of bank financing. By accelerating depreciation, your clients can write off a larger portion of qualified costs, therefore keeping more cash in their pockets. This positively impacts the bottom line and increases the likelihood of bank-financing eligibility.
- Clients can qualify for lower property taxes and insurance premiums. By reclassifying a portion of the cost basis into personal property, you decrease the amount of real property that is eligible for taxes. By the same token, because of less real property, the structure could also qualify for lower insurance premiums. This spillover benefit is an additional way to increase cash flow.
- It improves client relations. By improving your clients’ bottom line, you are adding value beyond your normal scope, which positions you as a trusted adviser. This could lead to more referrals.
- It is supported by the IRS. The IRS contends that field examiners should have a qualified background in engineering and construction to identify, segregate and document the details of the building. The 13 principal elements of a quality cost-segregation study, which are found in the techniques guide, should be followed for the IRS to even consider the findings.
- You can protect your clients and maximize results. By working with CPAs, you can extend the network of professionals who influence your clients. Recommending an engineering firm also benefits clients. It protects their best interests by encouraging them to work closely with another trusted adviser in addition to the CPA. It also allows for maximized results because the CPA has intimate knowledge of the business or building’s finances.
- It makes cash available for alternative investments. The time value of money is more apparent in today’s currency markets than ever before.
- It’s a simple, no-risk process. Most firms will give you a free analysis. Costs that qualify for accelerated depreciation are based on prior studies. Once clients determine a cost-benefit analysis with their CPA, they can choose to engage an engineering firm for a fee. Qualified engineers will visit the site and check the design of the electrical, mechanical and plumbing systems against the blueprints. They will also take photos and follow specific checklists to document all additional eligible costs. Once the study is complete, the engineer shares a draft report with the CPA, and when it is final, the CPA receives a final report. The CPA can then implement the findings to help the client realize the benefits of the study immediately.
Cost-segregation studies can impact a client’s bottom line positively. Brokers also would be well served to enrich the foundation of client relationships. As we push through the slow part of the economic cycle, cost segregation is one advantage worth looking into to develop more business.
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