Time Topic Pages Student Objectives 8:30-8:35 Course introduction Page 2 What is cost segregation? Objective of cost segregation: to increase cash flow Benefit of cost segregation Learning objectives Page 2 Know the history behind straight-line and cost segregation depreciation methods Determine properties that qualify for a cost segregation study Understand the impact of conventional straight-line cost recovery methods vs. cost segregation 8:35-8:40 Introductory concepts Page 3 History of depreciation as part of the income tax and its effect on commercial real estate investments Laws and regulations concerning depreciable items Methods depreciation: Straight line Declining balance Sum-of-the-years digits Income forecast Depreciation calculations based on adjusted basis; useful life (recovery period) and, historically salvage value of a property Shorter recovery period = larger tax deduction = greater tax incentive Maximizing personal property costs accelerates depreciation deductions 8:40-8:45 Methods of cost recovery Page 3-4 Commercial property changes to a building asset (depreciation) Dollar value of the property is entered into a fixed asset system as a 39- or 27.5- year property For the straight-line method, owners may take portion of purchase as taxable income as a deduction. Straight line is the only method for real property. Guidelines for the using the straight line method for cost recovery: All residential real estate improvements are 27.5-year class life property. Residential properties where people live for more than 30 days and no services are provided. (Example: apartment buildings) Health care facilities and nursing homes that provide full service do not qualify under residential for cost recovery they would be considered commercial. All commercial real estate improvements are 39-year class life property. Motels and hotels as well as office, retail, and industrial properties are classified as commercial properties. The actual depreciation allowance is found by multiplying the depreciation basis by the appropriate depreciation rate. The rate is a function of the cost recovery period and the methods. 1
8:45 8:50 Cost recovery deductions Page 4 Cost recovery deductions reduce income tax liabilities that result in an increase in after-tax cash flows. Deductions taken through cost recovery during the tax years of operation can be repaid when the property is sold or exchanged. Repayment may be in the form of capital gains taxes or in the form of costrecovery capture taxes. The investor must determine the depreciation basis and utilize the appropriate IRS table to calculate the percentage of qualifying deduction that is available for any given year. Only one column form the IRS table is used based on the month the property was placed in service. The investor is allowed to use this process to calculate the cost recovery deduction for each year they own the property. 8:50 8:55 Cost recovery recapture Page 4-5 The taxpayer relief act of 1997 changed the taxation of improved commercial and investment real estate. The non corporate taxpayer pays 25 percent marginal rate on straight-line cost recovery. 8:55 9:00 Introduction: Cost Segregation Study Page 6 Cost segregation study identifies and reclassifies personal property assets from real property to shorten depreciation time for taxes. A property must be placed into asset groups having the same recovery periods and placedin-service dates to calculate depreciation properly. Cost segregation or analysis occurs when only lump-sum costs are available. Cost estimating techniques may be required to "segregate" or "allocate" costs to individual components of property (e.g., land, land improvements, building equipment, furniture and fixtures, etc.) The underlying incentives for preparing cost segregation studies for federal income tax purposes are the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing the depreciation deductions. A key issue arises in the examination of the rationale used to segregate property into its various components, and the methods used to allocate the total project costs among these components. 2
9:00 9:05 Cost Segregation Study Page 7 Allocation and reallocation of building costs: Property allocation and reallocation is generally based on criteria established under the tax investment act. 1250 property has a39-year eligibility for depreciation. 1245 tangible personal property has 27.5-year depreciation and includes furniture, equipment and fixtures. By separating 1245 property from 1250 property, a faster depreciation write-off can be obtained by allocating costs to the 1245 property Cost segregation can also report building and occupancy items such as carpet, light fixtures, and doors as 1245 property. In addition, portions of the building components that directly support 1245 property, such as 15% of a building s electrical system, may be reported as1245 property Cost segregation studies vary in methodology, documentation, depth, format and expertise. A review of the study should include: Property classification Exact costs of property Specialist expertise, where applicable. Steps involved in a cost segregation study: Allocation of the value of the depreciable improvements, Classify the components based upon their depreciable lives and recovery periods using modified accelerated cost recovery system144 (MACRS) depreciation rules. 9:`05 9:15 Tax investment act Page 7, 8, 14 Legislative impact on qualifying property for depreciation: Property allocation generally based on criteria established under the tax investment act. The rate of depreciation for tangible property should be directly related to how property will be included in an acquisition or overall costs. Property qualifies as tangible personal property for purposes of ITC (under pre-1981 tax law) are also applicable to determining depreciation under current law. In 1997, the U. S. Tax court ruled the practice of segregating building costs for tax purposes was allowable. In 2004, the IRS finalized its cost segregation audit techniques guide, which lays out comprehensive audit techniques and explains what IRS auditors should look for in a cost segregation study. (Review this guide at the IRS website (www.irs.gov). 3
9:15 9:20 Cost segregation study Page 8 MACRS recovery period for assets Real property (IRS section 1250 property): Residential - 27.5 years Non-residential39 years (placed in service after 1993) Land improvements (IRS section 1250 property) Site improvements-15 years Personal property (IRS section 1245 property): Office furniture, fixtures and equipment 7 years Assets used in wholesale and retail trade, and personal and professional services - 5 years Commercial property qualifications: Acquired or built after 1/1/19877 Have improvements of $300,000 or more Owned by a for-profit entity Owner has taxable income: property will be held for another 3 to 5 years 9:20 9:25 Iris requirements Page 8 Owner cannot do his own cost segregation study An engineered cost segregation study will Identify permanent structural components of the building Identify improvements specific to the use of the building Insure compliance with IRS and court rulings and guidelines Cost segregation prohibited Page 8 If the owner has no income tax liability If the owner is going to sell the property in 3 to 5 years (depreciation recapture plus the cost of study could exceed early years benefits 9:25 9:30 Introduction to case study Page 9-11 Straight-line cost recovery vs. cost segregation: Case study objective: show the difference between the tax liabilities of a commercial property using the straight-line cost recovery method vs. the cost segregation method (given a qualifying property). Property qualifications: 45,000 square foot neighborhood shopping center for $4,780,000 Owner incurred acquisition costs of $50,000 Predicted property will produce an NOI of $430,200 for the first year of ownership Predicted to experience annual growth of 2% each year Loan costs -2% of loan amount Appraisal information: land/improvement allocation was 20% land and 80% improvement Disposition cap rate-9%; disposition cost of sale-4%, Allocation of the depreciable basis: 5 year useful life property-12.57%;7 year useful life property-0.45%;; 15 year useful life property-12.24%;39 year useful life property-74.74% 4
9:30 9:35 Owner finance details Page 11 Property was purchased with the following financing Loan amount-75% of purchase price 8% interest rate 10- year loan term A 25-year amortization period 12 payments per year 9:35 9:40 Owner assumptions/assignment Page 11-12 The owner has retained you to do an analysis to determine the impact on the after tax yield using conventional cost recovery vs. using cost segregation const recovery. Assignment: the owner has retained you to do an analysis to determine the impact on the after tax yield using conventional cost recovery versus using cost segregation. Analysis should: Provide the NPV of the tax saving using the after tax reinvestment rate as the discount rate for the NPV calculation. Reflect using the maximum amount of cost recovery allowed under cost segregation cost recovery rules. Look at various holding periods with the longest holding period being 10 years. Owner has provided the following tax and reinvestment rate information: Ordinary tax rate-35% Capital gain tax rate-15%cost Recovery recapture tax rate-25% After tax reinvestment rate-6%. 9:40 9:45 1st steps to study Page 20, 23 Preparing for the study creating advance documents Complete a one-page Client Profile Obtain a copy of your property s Depreciation Schedule Submit both for a No-Cost Benchmark Analysis Receive back a benchmark analysis which will show: Estimated accelerated depreciation schedule Estimated tax savings in the first year Estimated tax savings in future years Documentation required Property cost breakdown land vs. improvements Site plans Complete blueprints & specifications Tenant improvement plans and specifications Other documentation that is available to fine 9:45 10:00 Break Study process Review of the plans Inspection of the site Digital photo documentation Review of construction documents Analysis of all of the information Completion of the study 2 to 6 weeks. 5
10:00 10:05 Property benefits & reclassification Page 18 Types of buildings that can benefit from cost segregation: Existing buildings Newly constructed buildings Renovations New acquisitions - 1031 exchange properties Kinds of buildings that can benefit: Retail buildings; shopping centers; office buildings; restaurants; supermarkets; medical facilities; car washes; industrial; branch banks; hotels; manufacturing facilities; self storage; warehouse; multifamily; automotive facilities. Type of structure percentage reclassified Apartment buildings 15-40% Retail 10-40% Office buildings 10-25% Hotels 20-40% Warehouses 8-12% Light mfg 15-40% Heavy mfg 25-70% Processing plants 60-90% Nursing homes 15-30%.restaurants 15-40% 10:05-10:10 Tax benefit examples Page 19 Sample case study 1: Portfolio of 10 triple net properties acquired over last 10 years with $25 million depreciable basis: Over 29% of depreciable basis reclassified Resulting in $1.5 million tax savings/deferral in 2006 Sample case study 2 Two shopping centers acquired in 1987 and 1989 with a depreciable basis of $4.2 million 24.2% of depreciable basis reclassified. Resulting in over $180,000 tax savings/deferral in 2006. Sample case study 3 Free standing retail building acquired in may 1995 with $1.275 million depreciable basis 20.1% depreciable basis reclassified Resulting in $54,483 tax savings/deferral in 2006 10:10-10:15 Additional tax information The case studies show how to maximize tax savings by adjusting the timing of deductions. The depreciation expense is accelerated and tax payments were decreased during the early stages of the property life. In turn, cash for investment opportunities or current operating needs became available. Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties to increase cash flow in the current year. 6
10:15 10:25 Introduction to the financial calculator CD excel sheet section 2 TVM Time Value of Money (tab 3) An economic principle recognizing that a dollar today has greater value than a dollar in the future because of its earning power. (The worksheet replaces the keys on a hand held calculator.) Only cells accessible are input cells. Data input will show upon the component t- bar -the n component automatically calculated by multiplying the payments per year times the number of years. When you clear the sheets, the formula automatically resets. Annual NPV and IRR calculations (tab 4) NPV: the sum of all future cash flows discounted to present value and netted against the initial investment. IRR: the percentage rate earned on each dollar that remains in an investment each year. The IRR of an investment is the discount rate at which the sum of the present value of future cash flows equals the initial capital investment. For calculation of NPV and IRR for the real estate cash flow model. -formula allows you to enter the initial investment and up to ten cash flows. Sheet also allows you to enter the proceeds from sale at any time. Annuities for NPV and IRR (tab 5) Annuity: regular fixed payments or receipts over a designated period. Sheet can be used for any number of periods per year Sheet can accommodate up to fifteen different cash flows Unlimited number of repetitions for any cash flow Amortization schedule (tab 6) Amortization: the repayment of loan principal and interest through equal payments over a designated period. Calculation of an amortization schedule for a conventional loan. Calculation for period years of 1, 2 4 and 12. Periodic payments and the amortization schedule are based on four components: number of payments per year; amortization period (years); loan amount; and annual interest rate. Annual summary: (tab 7) summary of loan based on data entered in amortization schedule. Statistics (tab 8) Basic statistics for mean, median and standard deviation. 7
10:25 10:35 Cost segregation input sheet CD excel sheet 2-3 Property assumption components:: Acquisition price(cost to owner) Acquisition costs (additional costs related to purchase) Year1 NOI (Net Operating Income) Net Operating Income is the potential rental income plus other income, less vacancy, credit losses, and operating expenses. NOI annual growth rate Land basis Depreciable (loss of value of property) basis Cost segregation depreciable basis 5 year life (% depreciable basis) 7 year life (% of depreciable basis) 15 year life (% of depreciable basis) 39 year life (% of depreciable basis) Disposition Disposition cap rate (to the nearest $1000) Cap rate: a percentage that relates the value of an income-producing property to its future income, expressed as Net Operating Income divided by purchase price. Also known as cap rate. Disposition cost of sale Financial assumption components:: Loan amount (percentage of acquisition price) Interest rate Amortization period The period for the repayment of loan principal and interest through equal payment over a designated period. Term Payments per year Loan costs Investor assumption components:: ordinary tax rate Capital gain tax rate Tax rate on income derived from the sale of a capital asset. It equals the sale price less the costs of sale, adjusted basis, suspended losses, excess cost recovery and recapture of straight-line cost recovery. Cost recovery capture rate Anticipated holding period Cash flow analysis worksheet Acquisition data: purchase price plus acquisition costs plus loan costs minus mortgages equals initial investment. Mortgage data: amount, interest period, amortization period, load terms, payments, annual debt service, loan fees/costs. Basis data: purchase price; plus acquisition equals total basis minus land basis equals depreciation basis. Cost segregation data would also be included. Comparison of the conventional cost recovery versus cost segregation method. 8
10:35-10:50 Conventional and segregation recovery sales CD excel sheet 4-5 Explanations: Recovery: a period of increasing economic activity or a general economic upturn, typically following a stabilization of key sectors and industries. It is marked by increasing sales and recovering prices in real estate markets as a direct result of an external shock (for example, a favorable tax code revision) or an increase in demand for commercial real estate which, in turn, leads to the absorption of excess space. Little or no construction occurs during the initial stages of this phase until most of the excess space is absorbed or reasonable financing opportunities become available. Calculation for cost recovery Mortgage balance + EOY (end of year)/principal balance Calculation of sale price Calculation of adjusted basis: Original basis total cost recovery = adjusted basis at sale Calculation of capital gain: Sale price-adjusted basis = total gain - total cost recovery taken = Capital gain Items taxed as ordinary income + unamortized loan costs = ordinary income (loss) Calculation of sale proceeds: Sale price Cost of sale @ 0% - Mortgage balance = Sale proceeds before tax Tax on ordinary items @ 0% - Tax on cost recovery recapture @ 0% - Tax on capital gains @ 0% = 10:50 11:05 Case study calculations CD excel 1-5 Find cost recovery using assumptions given: Sale price: $4,780,000 Cost of sale: $50,000 Loan amount: 75% of purchase price Interest rate: 8% Loan term 10 years Depreciation basis: 5 years useful life -12.57% 7 years useful life 0.45% 15 year useful life 12.24% 39 year useful life -74.74% 11:05 11:15 Continuing education CE forms, state rosters, evaluations information/evaluations 11:15-11:25 Exam distribution and instructions 25 questions for exam Use color answer key 35 minutes to complete exam Return exam to instructor upon completion 11:25 12:00 Course exam 9