White, Paul L., Journal of Property Management
Recovering costs to maximize income tax savings
Every property and asset manager has the responsibility to continually improve the cash flow and value of the assets for which they are responsible. With several federal tax court decisions, we now have a valuable tool for increasing the after-tax cash flow of almost any commercial property. Through using cost segregation studies, owners can accelerate depreciation on many components of their properties over 5-, 7- and 15-year life periods.
With the passage of the Tax Reform Act of 1986, Congress changed how commercial real estate owners could depreciate their properties from several methods of accelerated depreciation to basically straight line depreciation, with residential properties having a life of 27 ½ years, and other commercial properties 31 ½ years. In 1993, the commercial properties were changed to 39 years. These changes had a significant impact on the after-tax cash flow for owners and contributed to the savings and loan crisis of the late 1980s.
In 1996, Walgreens (Walgreens Co. & Subs. v. Commissioner, 103 T.C. 582, 1994) won its challenge before the U.S. Tax Court to the practice of using a 39 ½ year costrecovery period for the improvements in its new free-standing stores, arguing that some of the fixtures and improvements in them should be classified with a shorter life.
The IRS acquiesced to this and other similar rulings; however, the judge modified his ruling to state that "in order for the cost segregation study to meet the minimum guidelines, the study had to be completed by individuals competent in construction or building techniques."
From 1997 to 2004, no clear guidelines existed for engineers to follow in conducting such studies; each study had to be extensive and exhaustive to meet the unknown requirements of the IRS. Few property owners could justify such studies.
In 2004, the IRS issued guidelines on what to look for in a cost segregation study, ultimately eliminating a great deal of unnecessary work for all involved. …