Cost Segregation is a tax savings strategy that in my view defies logic, yet nevertheless is a brilliant absolutely legal way to save taxes. What is Cost Segregation you ask? In essence, Cost Segregation separates out costs in a building into structural components which can be depreciated at tax advantageous rates. "Structural components" date back to the investment tax credit (ITC) real estate tax shelters in the late 1970s. Accelerated depreciation rules were enacted by Congress back then allowing “structural components" of a building to qualify for the ITC . More recently the US Tax Court validated "Cost Segregation" of structural components in Hospital Corporation of America vs IRS (1997). How does this help you? It could mean big tax savings for you if you own commercial real estate. So stay with us here on TaxView with Chris Moss CPA to learn how you can use cost segregation in your commercial or rental real estate for immediate annual income tax savings.
Do any of you remember the late 1970s ITC shelter partnerships? You would identify the structural components of a building you had just purchased, wrap the deal with a mortgage, add a little of your own money, use the ITC, and presto, you ended up with a large tax loss dramatically reducing your W2 income. By 1981 wealthy taxpayers were starting to discover real estate tax shelters. Just a few years later the hottest topic at any cocktail party throughout the country was tax shelters.
Now fast forward to 1986. The Tax Reform Act was designed to rid the nation of tax shelters and it did just that. The 1986 Reform Act repealed the ITC, prohibited passive losses from offsetting W2 income and dramatically lengthened depreciation of real estate.. All of a sudden commercial property you acquired was now depreciated over 31 year life rather than 19. (Just so you know, it’s 39 years now).
As the 1980s came to a close investors began to panic: No ITC and no rapid depreciation and no passive loss offset. Investors looked to their CPAs and their tax lawyers for relief. CPAs and tax lawyers in the early 90s partnering with structural engineers were surprised to find the IRS Code still contained the 1970s "structural component" classifications. Was this a simple Congressional oversight back in 1986 or did Congress intend to leave these provisions in the code for some reason? At any rate by the mid-90s tax shelter promoters were claiming that the 1970s classifications supported rapid depreciation of "structural components" as long as they were properly classified by competent structural engineers. It didn't take long for the IRS to start fighting back.
The battle soon moved to US Tax Court in Hospital Corporation of America vs IRS (1997). The facts are simple: Hospital Corporation (HC) was in the business of building and managing hospitals. HC segregated out various components of their many buildings as Section 1245 personal property allowing them to rapidly depreciate these components over a 5 year period. The IRS disallowed all this depreciation sending a $700 Million tax bill to HC for years 1978 to 1988. The Government argued that all the buildings must be depreciated over a much longer period of time as required for Section 1250 property by 1986 Tax Reform Act. The sole issue? Whether the structural components laws that remained in the Code from the 1970s were nevertheless still valid in 1997,
Judge Wells in his 116 page Opinion points out that Congress in the 1986 Act did not specifically address the 1970s provisions of the Code that were created to facilitate the ITC back then. The Court noted that the statutory language manifested a Congressional intent to retain the prior law distinction between components that constitute Section 1250 real estate and items that constitute Section 1245 personal property.
With the US Tax Court giving its blessing, and the IRS acquiescing, a billion dollar
"cost segregation" industry was born to “segregate out” the cost of the tangible Section 1245 portion of a building. With a good engineering analysis the CPAs were able to confidently and legally rapidly depreciate substantial parts of commercial buildings on annual tax returns knowing they could win an IRS audit.
What does all this mean to you all? First and most important: Cost Segregation is legal folks but only if your experts are better than the Governments. So if you are purchasing a building, hire the best structural engineering firm you can afford and segregate out those costs into structural components that will qualify for rapid deprecation and immediate tax savings. Second, make sure your tax attorney and structural engineers guarantee their work so when the IRS comes knocking on your door, the same people who did your analysis will be there at no extra charge to act as your expert witnesses at a possible US Tax Court trial. Likewise ask that the same tax attorney who prepared your tax return to guarantee that she will be there for the IRS audit and a trip to US Tax Court if needed.. Finally, don't forget to include your structural engineering cost segregation report summary in the actual tax return you file with the IRS. When you are audited years later you will be glad you did..
We hope you enjoyed this weeks TaxView with Chris Moss CPA.
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Chris Moss CPA