Release Powerful, Underutilized Tax-Saving Strategies for Commercial and Investment Real properties

1

Understanding The Latest IRS Updates Relative to
Cost Segregation Studies

• Release Powerful, Underutilized Tax-Saving
  Strategies for Commercial and Investment Real
  properties

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2
Goal of Cost Segregation Studies
Would you Rather Get Your Money Back Today or in
39 Years?

• Goal to identify all construction-related costs
  that can be depreciated over 5, 7 and 15 years
  and reclassified from 39, 31.5 and 27.5 years
• Traditional depreciation for Real Property is 39
  years for commercial property and 27.5 years for
  residential rental property
• Personal property is depreciated much quicker and
  can be depreciated over 5, 7, 10, and 15 years
• Reducing tax lives results in accelerated
  depreciation deductions, a reduced tax liability,
  and increased cash flow

3
Major Benefits to The Property Owners?

• Generates Cash Flow and Minimizes Taxes
• Look back study for catch-up of depreciation
  could generate refund
• Free up money for investments which allows for
  compounded growth
• Benefit to clients includes ability to expense
  versus capitalization of real property when
  conducting demolition or when remodeling is
  involved.
• Reduces real estate property taxes
• Increase Cash Flow for Maximum Bank Financing
• Section 179 Benefits
• Reduced Insurance premiums

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So What Is The Big Deal?

• The depreciation for a property with a Cost
  Segregation Study allows for significant increase
  in deductions within the first five years.
• For every 100,000 of cost shifting from 39-year
  property to 5-year property, the net present
  value of the tax benefit is approximately
  16,000
• For 100,000 of cost shifted from 39-year
  property to 15-year property, the net present
  value of the tax benefit is approximately10,600
• Benefits assume a tax rate of 35 and a 5
  return on investment

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Timing Illustration
6
CSS Brief History

• CS has been around since the 1960s it was
  called Component Depreciation
• There have been over 200 court cases and IRS
  rulings supporting the benefits of CS
• Initial cases were related to Investment Tax
  Credit (ITC) and whether items related to a
  structure could qualify for a credit.
• Congress enacted ACRS 1981 with new shorter lives
• 40 year life reduced to 15, 18 19 years
• Simultaneously disallowed component depreciation
• MACRS enacted in 1986 reiterated disallowance of
  component depreciation

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Hospital Corporation of AmericaLandmark
Decision - 109 TC 21(1997)

• Court reinstated and expanded a form of component
  depreciation
• Certain costs related to specific ordinary use
  equipment (building support systems that would
  otherwise be viewed as structural) qualify to be
  depreciated over life of underlying asset.
• IRS acquiesced to Tax Court Ruling - 1999

8
CSS Brief History

• In 1999, the IRS released Legal Memorandum
  19921045 in which the IRS agreed not to contest
  the (HCA) reclassification of building costs into
  different asset categories that result in shorter
  depreciation lives
• This legal memorandum directs agents to verify
  that an engineering or architectural study has
  been done to identify portions of the building's
  system not related to the operation and
  maintenance of the building
• Without these detailed studies, IRS agents are
  advised NOT to accept the reclassifications
• is a facts and circumstances assessment
• Use of Cost Segregation Study (CSS) must be
  specifically applied by the taxpayer
• Allocations based on logical and objective
  measures
• Not based on non-contemporaneous data, or
  assumptions without supporting records
• CSS must be closely scrutinized by the field

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IRS - Audit Technique Guide

• Issued in April 2004
• Developed to assist Field Examiners
• WHY are cost segregation studies performed?
• HOW are they prepared?
• WHAT to review and look for?
• IRS Cost Segregation Audit Techniques Guide
  Assist Field Examiners
• Why are CSS performed?
• How they are prepared?
• What to review and look for?

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What is being said about Cost Segregation?
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Qualifying Property

• Any building placed in service since January 1st,
  1987
• Existing buildings undergoing renovation,
  remodeling, restoration, or expansion
• Major leasehold improvements to any building made
  after January 1st, 1987
• Inheritance of commercial and investment real
  properties
• Preconstruction planning to recommend possible
  modification to the building designs to increase
  shorter-life asset classification

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Cost Segregation for an Existing BuildingCatch
Up Look Back

• If a cost segregation study is conducted on an
  existing building,
• The unclaimed depreciation on personal property
  components that were previously classified as
  real property can be deducted as a Code Sec. 481
  (a) adjustment in the year of change
• The automatic change of accounting rules of Rev.
  Proc. 2002-9, apply
• If a cost segregation study is performed on a
  building that was placed in service in a tax year
  that ended before December 30, 2003,
• The IRS will allow a tax payer to file amended
  returns to claim the benefits
• Interest is payable by the IRS on the refund

13
Cost Segregation Studies IncludesNew and
Previously Acquired Properties

• The optimal time to perform a study is the year
  the property is placed in service
• Current IRS procedures allow a taxpayer to
  recover any missed depreciation on properties
  placed in service as far back as 1987 without
  having to amend prior years tax returns
• Cost Segregation is not limited to new
  construction. In fact, most studies are
  performed on acquired properties where land and
  building is purchased for one negotiated price in
  a previous year

MACRS - GDS 39 - Year Property 27.5 Year
Property 15 - Year Property 7 - Year
Property 5 - Year Property 3 Year Property
OR
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Benefit of Cost Segregation Cash Flow Would
You Take the Cash Savings Today?
CSS Illustration No. 1

• A taxpayer purchases (or constructs) a strip mall
  for 4 million (land excluded)
• Without a Cost Segregation Study, the taxpayer
  would have depreciated 4,000,000 as a 39-year
  asset over 40 years (straight-line, HY convention)

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Benefit of Cost Segregation Cash Flow Would
You Take the Cash Savings Today?
CSS Illustration No. 1- (continued)

• By segregating assets and applying proper class
  lives, significant portion of the building can be
  depreciated faster
• Typically, about 35 of total cost can be
  reclassified from real property to personal
  property for this type of building

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Benefit of Cost Segregation Cash Flow Would
You Take the Cash Savings Today?
CSS Illustration Continued

• Cash savings of 320,282 can be achieved over the
  fist 5 years w/ CSS
• Although cash savings / tax savings over the tax
  life of the building does not exist, net present
  value of the earlier tax savings or deferred
  taxes due to accelerated depreciation results in
  net present value of 200,000!

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Again, What is the Big Deal?
FASTER CASH FLOW!

• The depreciation for a property with a Cost
  Segregation Study allows for significant increase
  in deductions within the first five years.
• For every 100,000 of cost shifting from 39-year
  property to 5-year property, the net present
  value of the tax benefit is approximately
  16,000 (NPV 16.00 per 100
  invested)
• For 100,000 of cost shifted from 39-year
  property to 15-year property, the net present
  value of the tax benefit is approximately10,600
  (NPV 10.60 per 100
  invested)
• Benefits assume a tax rate of 35 and a 5
  return on investment

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Why are the CPA and Engineer Important in the CSS
Process?

• First element of a quality Cost Segregation Study
  according to the IRS Audit Techniques Guide is
• Provider who marries the science of engineering
  with the principles of tax and accounting to
  arrive at financial solutions that results in
  increased cash flow, minimized tax payments and
  increased ROI. A firm that meticulously follow
  the IRS guidelines and go beyond the standards
  and basic requirements outlined by the IRS
• Prepared by an individual with expertise and
  experience.
• Select CPAs and engineers familiar with
  engineering, construction, architectural and
  estimating processes and techniques are essential
  for a quality CSS process.
• Select CPAs and engineers with appropriate tax
  background and knowledge of over 200 court cases,
  many revenue ruling and revenue procedures
  dealing with cost segregation area are essential
  for a quality CSS.
• Additional Considerations
• I think Audit should be first
• I would also add preconstruction
• Must understand abandonment issues
• Knowledgeable on issues involved with 1031
  1033 exchanges and how they interact with Cost
  Segregation
• Must have expertise in Form 3115 Change in
  Accounting Method filing procedures
• Understanding how Cost Segregation can affect
  estate taxes, passive loss situations, IRS 179
  deductions, Net Operating Loss situations,
  168(k),
• partnership 754 step-up elections and
  other tax situations
• Experience in lease review and identification of
• qualified leasehold property
• Does the CSS include time for audit support

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Tax Planning Other Benefits

• Insurance Premiums
• Recapture
• Closing Costs (doc stamps)
• Property Tax Benefits (RE vs. Tangible PP)
• Preconstruction recommendations
• Lessor
• Lessee

• Demolition Loss expense vs capitalize
• Estate Planning Strategies
• 1031 Exchange Strategies
• Real Estate Professional
• Passive Taxpayer Multiple Entities

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1031 Exchanges Planning With CSS
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Why do I need an Engineering Expertise for a CSS?
3 Words Mechanical, Electrical, Plumbing

• Cost segregation study (CSS) is an IRS-sanction
  technique allowing businesses to accelerate
  depreciation on their facilities
• Although the IRS does not prescribe one specific
  methodology, the IRS Cost Segregation Audit
  Technique Guide does not enumerate several and
  elevates the Detailed Engineering Approach From
  Actual Cost Records as the most methodical and
  accurate approach
• This approach consists of carefully examining all
  contemporaneous construction and accounting
  records
• Estimates or take-offs are used to supplement
  the actual cost detail when the existing detail
  is not sufficient for the purposes of the study
• A professional firm comprised of accountants,
  engineers, and architects with prior cost
  segregation experience, is required to perform
  this kind of cost segregation study
• Methodology without the engineering expertise
  will not withstand IRS scrutiny in accordance
  with the IRS Audit Technique Guidelines
• Without the contractor/engineering expertise
  coupled with the tax law guidance, there will
  likely be valuable tax benefits left on the table
• Determining 1245 property value on existing
• properties must be properly documented and
• appraised and indicated according to the
  IRS
• Audit Technique Guidelines

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Detailed Engineering Approach

• Identify the specific project/assets that will be
  analyzed
• Obtain a complete listing of all project costs
  and substantiate the total project costs
• Inspect the facility to determine the nature of
  the project and its intended use
• Photograph specific property items for reference.
• Review as-built prints, specifications,
  contracts, bid documents, contractor invoices and
  other construction documentation.
• Identify and assign specific project items to
  property classes
• Prepare quantitative take-offs for all materials
  and payment records to compute actual unit costs

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Qualifying Property
Property Types
Airports Apartment buildings Assisted Living
Facilities Automobile dealerships Automotive
service centers Banks Casinos Cinemas Day care
centers Department stores Distribution
centers Fitness centers Funeral homes

• Gas stations
• Golf resorts
• Grocery stores Hospitals
• Hotels
• Industrial facilities
• Laboratories
• Manufacturing facilities
• Marinas
• Medical facilities
• Mixed-use facilities
• Nursing homes
• Office buildings

• Research facilities
• Retail centers
• Resorts
• Restaurants
• Service stations
• Shopping centers
• Sports facilities
• Storage facilities
• Warehouses

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Which Properties Benefit Most?
Property Type
Percentage Reallocated
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Cost Segregation Recent Results
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Look Back Example
CSS Look back Example

• A taxpayer purchased (or constructed) a strip
  mall for 4 million (land excluded) in 2000
• Without a Cost Segregation Study, the taxpayer
  has been depreciating 4,000,000 as a 39-year
  asset over 40 years (straight-line, HY convention)

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Look Back Example continued
CSS Look Back Example (continued)
IRS Owes The Property Owner 336,604!

• What could you do with the new found money of
  336,604 that was trapped in the walls of your
  investment?
• Make additional investment
• Reduce mortgage debt
• Address maintenance items

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Examples of Pre-Construction Benefits

• Pre-Construction Planning In the design phase,
  CORE can help make the building more tax
  efficient by identifying business components from
  the structural components
• Example Law Firm uses hinges for 1MM decorative
  lobby shelving versus attaching shelving with a
  permanent adhesive
• Total property is able to be moved from 39-year
  depreciation to 5-year depreciation for a
  tremendous savings
• Example Hospital installs 1.8MM floating floor
  system versus permanent attached flooring
• Structurally as sound, cash savings from more
  attractive depreciation schedule substantial

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Insurance Savings Alone May Pay forCost
Segregation Study

• There are a number of benefits to your insurance
  program after completing a Cost Segregation
  study
• Lower premiums. By providing the insurance
  underwriter with a Cost Segregation study, they
  can better understand your risk, their companys
  exposure and accurately rate your insurance
• There is no more guess work on the underwriters
  behalf and that guess work usually works in their
  favor in the way of higher premiums to you
• In the wake of the recent natural disasters
  affecting the insurance market, most insurance
  policies are changing from blanket policies to
  stated value
• Each location will carry a stated value on the
  policy and in the event of a claim that is the
  maximum you can collect
• A Cost Segregation study will provide you with
  the piece of mind that you are insured to full
  value
• Cost segregation studies allow property owners to
  accurately insure their business property,
  leading to a more cost effective use of your
  insurance dollar

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Additional Benefits from CSS Demolition/Rehabilita
tion

• Ability to identify components of a building
  prior to demolition and/or rehabilitation which
  can be reclassified as personal property versus
  real property
• Allows the owner to write off these items versus
  capitalizing the assets which generate a
  substantial tax savings
• For example, if a property owner has a 5-million
  property that they are going to demolish
• The total cost would typically get applied to the
  land with the property owner having no ability to
  depreciate or recoup the 5-million investment
• A cost segregation study, prior to the
  demolition, identifies 1,500,000 of personal
  property
• The property owner will now be able to write off
  the 1,500,000 as abandoned personal property

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Real Estate Investment Trusts (REITs) Benefit

• Increase non-cash expense to reduce income and
  thus minimize dividend distribution, allowing
  increased cash flow for additional acquisitions
• REIT dividends have 3 components
• Ordinary Dividends
• Long-Term Capital Gains Dividends
• Return of Capital Dividends
• Due to the favorable tax treatment of Return of
  Capital Dividends (taxed at the long-term capital
  gains rate of 15 or 25 and tax payment is
  deferred until the sale of the share), investors
  typically prefer dividends with the greatest
  percentage of Return of Capital
• Cost Segregation increases the Return of Capital
  component thereby, increasing the Taxable
  Equivalent Yield
• DIVIDEND GROWTH IS INCREASED
• A significant source of dividend growth is
  acquisitions
• REIT must pay out a minimum of 90 of taxable
  income as dividends, and many REITs pay out over
  100 of taxable income.

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Cost Segregation Asset Class Lives for
Restaurants

• The crux of cost segregation is determining
  whether an asset is I.R.C.
• 1245 property (shorter cost recovery period
  property, 5 or 7 years) e.g., depreciable
  personal property, such as equipment or
• 1250 property (longer cost recovery period
  property, 39, 31.5 or 15 years) e.g., buildings
  and building components, which generally are not
  1245 property
• The Director for the Retailers, Food,
  Pharmaceuticals and Healthcare Industry chartered
  a working group to address the most efficient way
  to approach cost segregation issues specific to
  the restaurant industry
• The group produced a special section related to
  the required cost segregation study for such
  purposes

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Cost Segregation and 1031 Exchanges- Best of
Both Worlds -

• Most valuable tax deferral strategies for real
  estate are
• Cost Segregation (Accelerated depreciation of
  real estate)
• 1031 Exchanges (Deferral on the disposition of
  appreciated property)
• How To Best Utilize Both Strategies
• Real Estate Investors and their advisors must
  understand issues in utilizing both strategies
• Real vs. Personal Property
• Real and personal property under section 1031 is
  determined by state law
• In contrast, the definition of real and personal
  property for cost segregation studies is
  determined under federal law
• Property such as wall coverings, carpeting,
  special purpose wiring or other installations
  affixed to the building can be considered real
  property under state law and like kind for
  section 1031 purposes, but be considered personal
  property in cost segregation studies
• Real estate owners can benefit from both the gain
  deferral under section 1031 for real estate
  exchanges and the enhanced cost recovery
  deductions of cost segregation study

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IRS Determination/Tests - Structure or Personal?
Factors that now govern whether property is
permanent or can be reclassified in accordance
with IRS Audit Technique Guidelines

• Permanency test - Sec. 1.48-1 (c)
• Is the property capable of being moved?
• Has it been moved?
• Is the property designed or constructed to remain
  permanently in place?
• Are there circumstances which tend to show the
  expected or intended length of affixation - i.e.
  may or will be moved?
• How substantial of a job is removal of the
  property how time consuming?
• Is it readily movable?
• How much damage will the property sustain upon
  removal?
• What is the manner of affixation of the property
  to the land?

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IRS Determination/Tests - Structure or Personal?
Appearance and Function Test

• The appearance test
• Whether the structure looks like a building
• Generally only requires that the structure
  enclose a space within its walls and usually be
  covered by a roof
• The second part of the test requires that the
  building function as a building
• The courts primarily focused on whether the
  structure provides working space for employees
  that is more the merely incidental to the primary
  function of the structure
• Both the quantity and qualify of human activity
  inside the structure may be considered in this
  regard

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Items To Be Reclassified in a Cost Segregation
Study

• Site Improvements (landscaping/parking)
• Light Fixtures
• Branch wiring
• Special Plumbing
• Flooring
• Millwork
• Millwork Window Coverings
• Partition Walls
• Cabinetry
• Furnishings
• Shelving
• Wall Coverings

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Qualified Property
Partitions

• Property to include
• Accordion-style room dividers
• Decorative lattice millwork used to separate
  areas
• These items are not permanent structures
  therefore do not affect the operation nor
  maintenance of the building
• 1245 property

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UNIQUE ASSETS TO IDENTIFY
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Qualified Property
Primary and Secondary Electrical Distribution
Systems

• Property to include
• Main panels
• Motor control centers
• Transformers
• Main distribution panel switchgear
• Related wiring and conduit
• The courts conclude that the portion of the cost
  of the primary and secondary electrical
  distribution systems which is equal to the
  percentage of the electrical load carried to
  those systems allocable to the property
  equipment, as stipulated constitutes the 1245
  qualification class property and is depreciable
  over an accelerated life

40
Qualified Property
Branch Electrical Wiring and Connections, and
Special Electrical Equipment

• Property to include
• Controls
• Battery packs
• Battery chargers for emergency power equipment
• Illuminated emergency and entrance signs
• Medical gas control and alarm equipment
• Kitchen equipment
• Wired clock systems
• Normally 100 of the load carried relates to
  this type of equipment, therefore the balance of
  the electrical is normally allocated to the
  building

41
Qualified Property
Electrical Wiring Relating to Internal
Communications

• Property to include
• Conduit
• Wiring
• Electrical connections

• Systems supported
• Call systems
• Intercommunication systems
• Dictation systems
• Music systems
• Paging systems

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Qualified Property
Wiring and Related Property Items Relating to
Television Equipment

• Property to include
• Branch electrical wiring
• Conduit, floor boxes
• Junction boxes
• Outlet receptacles
• All other equipment in connection with its
  operation

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Qualified Property
Kitchen Plumbing

• Property to include
• Items relating to operation of grease trap
  systems
• Trench drains
• Grease waste piping
• Waste excavation
• Waste fill
• Trap itself
• All connections (hose and reel connections)
• Water piping used for operation of kitchen
  equipment

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Qualified Property
Kitchen Hoods and Exhaust Systems

• Property to include
• Air intake fans related duct work
• Dishwasher condensate return units
• These items ventilate air, remove humidity and
  steam, replace air expelled
• Test
• Do the items relate to the buildings operation or
  maintenance?
• NO! Therefore are considered Section 1245
  property

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Sample Report Engineering Calculations Per
IRS Guidelines
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Sample Report Depreciation AnalysisPer IRS
Guidelines
47
Sample Report Depreciation SchedulePer IRS
Guidelines
48
Sample Report Tax References Per IRS Guidelines
49
The Cost Segregation Study Process
Continued
Electrical
Site Work
Landscaping
50
The Cost Segregation Study Process
Prepare final reconciliation Prepare final
report Deliver Draft Review with tax
advisor Deliver Final Study with sample 3115
51
Summary

• Time Value of Money
• Dramatic reduction in taxable income
• Increased cash flow for investment opportunities
  and business expansion
• Property tax savings
• Insurance savings

www.bestbottomlines.com (888)-598-9667
52
I.R.C 1031 Key Points

• A 1031 Exchange rolls the gain from the sale of
  an Old Property into a New Property - Without
  having to pay tax
• There is no limit to the number of times you can
  do a 1031 Exchange
• Hold Property 1 year 1 day

53
Property Use and Title

• Property given up and property received must be
  held for productive business use or investment
• Real Property
• Personal Property
• Property given up and property received must be
  held by the same taxpayer (i.e. Same Tax ID )

54
Timeline Rules

• 45 Day Identification Period
• The Exchangor must identify the potential
  replacement property by midnight of the 45th day
  from the date of the sale
• 180 Day Exchange Period
• The Exchangor must acquire the replacement
  property by midnight of the 180th day, or the
  date the taxpayer must file its tax return
  (including extensions) for the year of the
  transfer of the relinquished property, whichever
  is earlier

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1031 Exchange Timeline

• 45/180 Day Rules

Start Day 1
Finish Day 180
Identification Date Day 45
Close of Escrow On Purchase Property (AEC to fund
proceeds)
Close of Escrow On Sale Property (Net Proceeds to
AEC)
ID Form Due To AEC
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Replacement Identification Rules

• 3 Property Rule Three properties of any value
• OR
• 200 Percent Rule Any number of properties as
  long as their combined fair market value does not
  exceed 200 percent of the value of the sold
  property
• OR
• 95 Percent Rule Any number of Replacement
  Properties, of any value, but only if the
  Exchangor buys at least 95 of the aggregate fair
  market value of all identified Replacement
  Properties

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Reinvestment Requirement

• Equal or Up
• Purchase price of NEW Property must be equal to
  or greater than the net selling price of OLD
  Property
• Reinvest All The Cash
• You must reinvest all of the cash. Any cash you
  touch will be taxable

58
Constructive Receipt

• What is Constructive Receipt?
• Main Reason Taxpayers flunk 1031
• Funds credited to taxpayer account or made
  available for use
• Funds credited to a Disqualified Person on
  behalf of taxpayer are treated as credited to
  taxpayer
• Safe Harbor from Constructive Receipt Qualified
  Intermediary

59
Functions of QI

• Prepare Documentation
• Act as Trustee
• Funds Deferred Exchanges
• Property Reverse Exchanges
• Consulting

60
AEC 1031 Exchange, LLC

• Reverse Exchange

61
AEC 1031 Exchange, LLC

• Basic Concept
• Buy a New Property
• BEFORE
• Selling Old Property

62
Advantages of 1031 Exchanges
Why Do A Reverse Exchange?

• Act quickly to acquire New property
• Old property sale is delayed
• Effectively extends 45 and 180 time limits
• Allows adequate time for Due Diligence

63
1031 Exchange Timeline
Reverse Exchange - 45/180 Day Rules
Finish Day 180
Locate New Property
Identification Date Day 45
Close of Escrow On New Purchased Property
ID Form Due To AEC
Close of Escrow On Sale of Old Property
Due Diligence Period
64
AEC 1031 Exchange, LLC

• Key Point
• Taxpayer cannot receive and own both OLD and NEW
  property at the same time

65
AEC 1031 Exchange, LLC

• Two Reverse Methods
• Give up OLD property to EAT before receiving
  NEW property
• NEW property is received by EAT and held in
  trust for taxpayer until OLD property is sold

66
AEC 1031 Exchange, LLC

• Business started as Alaska Exchange Corporation
  (AEC)
• Over 20 years experience
• 1000s of Exchanges all 50 states
• Interest paid on trust funds
• Specialize in providing exchange strategies and
  guidance