Building Foundations for the Future

Cost Segregation – The Key to Maximizing Cash Flow

Cost segregation – an analogy!

If you won the lottery for $3.9 million dollars, would you:

a. Take your payout of $100,000 a year for 39 years, or

b. Take a lump sum payment?

Why?

What is Cost Segregation?

Cost Segregation (CS) is a strategic approach to maximizing investment cash flow for property owners who have built, purchased, added to, or remodeled real estate.

A Cost segregation study segregates the costs and the useful lives of the individual property components for tax advantages.

Case study

Your practice buys improved land and builds a brand new facility.

Here are the details:Land Cost = $725k (land) + $375k (land

improvements)= $1,100,000Building Cost = $3,900,000Total Costs = $5,000,000

Option #1

The IRS allows owners to depreciate (and deduct from corporate taxes) the cost of the building over 39 years, so:

Building Cost of $3,900,000 / 39 yrs = $100,000/yrNote: Land improvements not segregated and not depreciated

90% of people choose option number 1 because they do not understand Option #2

Option #2

The IRS also allows owners to segregate the different costs of the building and depreciate (and deduct from corporate taxes) the cost of each of these items by its expected life.

For example, carpeting does not last 39 years, why depreciate it over 39 years?

There are four categories of property:Land (not depreciable)Land Improvements (parking lots, etc.) – 15 yearsCertain Personal Property – 7 yearsMost Personal Property (Carpet, cabinets) – 5 years

Option #2 - continued

Using the same cost data and based upon a “Cost Segregation Study,” the building components have been broken out as follows:

Land - $ 725,000Land Improvements - $ 375,000Building structure - $2,715,0005 Yr Personal Property - $1,185,000

Total Cost $5,000,000

Option #2 - continued

Applying the IRS approved depreciation rates we have the following deductions

Land - $ 725,000 (not depreciable)Lanprovements $ 375,000 / 15yr = $ 25,000Building structure - $2,715,000 /39 yr = $ 69,615Personal property $1,185,000 / 5 yr = $237,000Total Annual Depreciation (1st 5 years)=$331,615

Options 1 & 2 - compared

Option #1 – we have a $100,000 annual deduction for 39 years

Option #2 – We have a $331,615 annual deduction for 5 years, plus a $94,615 deduction for the next 10 years and a $69,615 deduction for the last 24 years

Which would you prefer?

Options 1 & 2 - net present value @8%

Option #1 – we have a $100,000 annual deduction for 39 years= npv of $1,187,858

Option #2 – We have a $331,615 annual deduction for 5 years, plus a $94,615 deduction for the next 10 years and a $69,615 deduction for the last 24 years for a npv of $1,987,191

Option #2 confers $799,333 greater benefit!!

Another benefit of CSS

Consider this: You construct a new building for a total cost of $5,000,000. You do NOT do a CSS. Two years later the HVAC breaks down and must be replaced at a cost of $390,000. There is NO tax benefit!

Same scenario but you have a CSS prepared which identifies the HVAC construction cost at $390,000. You have depreciated this cost $20,000 ($390k/39 yrs = $10k per year x 2 yrs=$20,000). In this scenario, you can deduct the remaining value ($370,000) from your taxes!

And yet one more example:

Consider this: You purchase a building which will be renovated for $2,000,000. You demolish the interior and renovate the space at a cost of $2,000,000. You do NOT do a CSS. No Current Tax Benefit!

Same scenario but you have a CSS prepared which identifies the personal property at a value of $500,000. You demolish the interior and renovate the space at a cost of $2,000,000. In this scenario, you can deduct the value of the demolished personal property ($500,000) from your taxes!

A word about Leasing

Cost segregation can also be applied to leasehold improvements provided there is documentation with a cost schedule describing components paid for by owner and tenant.

If costs not identified, you cannot depreciate.

IMPORTANT and rarely used: Tenant can deduct the full amount of his basis at end of lease term

Example: Tenant provides flooring and cabinetry at a cost of $30,000 which he can depreciate over 5 years at $6,000/yr.

Tenant moves at end of 3 years. He can deduct the remaining $12,000 from taxes. ($30,000 - $18,000 = $12,000)

Cost segregation – who can benefit?

�Purchased property within the last 6 years�Constructed building within last 6 years�Purchased property with intent to renovate�Invested in significant property improvements�Invested in significant tenant improvements

What types of properties can benefit?

�Medical offices�Surgery centers�Diagnostic & radiology centers�Oncology treatment centers�Laboratories�Assisted Living Facilities�Nursing homes�Hotels�Restaurants

Why do a Cost Segregation Study (CSS)?

• Match depreciation to real, expected rates• Lower your taxable income• Maximize your cash flow

“CPAs should routinely recommend the use of

cost segregation studies�”~ Journal of Accountancy

IRS Requirements for Effective Study

The primary reason most CPA firms do not provide CSS is because they do not have the engineering expertise to effectively carry out the work.

This requirement is explicitly described in the IRS Guidebook.

Three IRSRequirements

CPA orTax Pro

Cost Expert

Architect-Engineer

In conclusion

I believe that Cost Segregation Studies and their benefits are the most under utilized tax advantage available to every facility owner.

I also believe that every practice that pays for tenant improvements should address this benefit in their lease and should evaluate the benefits of commissioning a CSS.

For more information, contact:

Frank RicciPrincipal

Healthcare Realty & Development Services300 N. New York Avenue

Suite 2802Winter Park, FL 32789

Ph: 407-947-5074Email: HealthcareRealtyServices@gmail.com