Cost Segregation and Tangible Property Repair Regulations

Cost Segregation & Tangible Property

Repair RegulationsMark Heath – McKonly & Asbury

Gian Pazzia - KBKG

Cost Segregation & Tangible Property

Repair RegulationsMark Heath – McKonly & Asbury

Gian Pazzia - KBKG

SOLUTIONS FOR TAX PROFESSIONALS AND BUSINESSESTAX CREDITS • INCENTIVES • COST RECOVERY

Tangible Property Repair Regulations& Cost Segregation

Gian Pazzia, CCSPPrincipal

http://www.kbkg.com/

Tax Credits · Incentives · Cost Recovery | Nationwide Service | © KBKG 2015

Established in 1999 with offices across the US. Provide turn-key tax solutions to CPAs and businesses

R&D Tax Credits, Cost Segregation, Energy Tax Incentives, Repair vs. Capitalization Studies, IC-DISC Export Incentives

Performed thousands of tax projects resulting in hundreds of millions of dollars in benefits for our clients.

Our team is a diverse mix of tax specialists, attorneys, energy consultants and engineers from various disciplines. This combination of talent allows us to focus on our areas of service and maximize results for our clients.

A preferred provider for thousands of CPAs across the country.

About KBKG, Inc.


Principal at KBKG, Civil Engineer ASCSP Certified Cost Segregation Specialist, #C0029-07 American Society of Cost Segregation Professionals

• 2013-2015, President• 2009-2013, Chair Technical Standards Committee • 2007-2017, Board of Directors

Expert witness for cost segregation matters before the IRS Instructor and Author for numerous national educational groups Background with Big 4 CPA firms American Society of Civil Engineers Purdue University, West Lafayette IN

• Structural Engineering• GO BOILERMAKERS!

Gian Pazzia, CCSP


The process of breaking a building’s cost down into individual components for tax depreciation purposes. Typically conducted by an engineer.

• Acquired Property* • New Construction*

* (as far back as 1987)

Cost Segregation

MACRS - GDS

39 - Year Property27.5 - Year Property15 - Year Property7 - Year Property5 - Year Property3 – Year Property

• Remodeled Property*• Build-outs*


Primary goal: identify all property-related costs that can be depreciated faster (typically with a 5, 7 or 15 years tax life). Taking tax deductions earlier increases cash flow Creates a time value of money benefit by having cash now and not later

Secondary goal: establish the depreciable tax value for each major building component that is likely to be replaced in the future. Examples include the roof, windows, doors, bathroom fixtures, HVAC,

and so on. Tax preparer’s need this information to claim a “retirement loss” or

“partial disposition” deduction for the remaining depreciation left on that component.

Cost Segregation


Benefit: Accelerated Depreciation Deductions

KBKG, INC. COST SEGREGATION SPECIALISTS


$3 million retail building Without a Cost Segregation Study the costs are depreciated straight line over

39 years.

Example: Retail Building Current Year Acquisition

KBKG, INC. COST SEGREGATION SPECIALISTS

Benefits reclassifying from 39 Year Life$330,000 depreciated over 5 years$360,000 depreciated over 15 years

Increased Deductions - first 5 years: $367,000Projected Benefits: $126,000

With a Cost Segregation Study


One of the most common tax planning tools for anyone with real estate Performed in year purchased – simply report the allocations on

depreciation schedule

Cost segregation can done anytime after the building is purchased. No amended tax returns. File a Form 3115 and claim any missed deductions in year performed. Allows tax preparers to plan when to use deductions

Cost Segregation – Tax Planning Tool


Depreciation deductions will reduce AMT On new construction or renovations, bonus depreciation can apply to

reclassified items in a cost segregation study Magnifies benefits

Unused deductions carry forward Accounting method changes – Form 3115 Passive activity rules

If RE activity is passive, must us the deductions against passive income When building is sold, may need to recapture depreciation taken on

personal property

Tax Considerations


Any building or improvement costs incurred in the last 20 years. Needs to be enough “depreciable” basis (purchase price less land value)

Commercial Freestanding Buildings > $750,000 Residential Freestanding Buildings or Condos > $150,000

Using software Renovations/Improvement Costs > $500,000

Cost Segregation – Good Candidates

• Remodeled Property*• Build-outs*

• Acquired Property• New Construction


Self Rental Rule

Can’t use losses from a separate real estate entity (if it's a passive activity) against active income.

Results = S-Corp can not use losses from LLC. Tax = $40k (assuming 40% tax rate)

Taxpayer

S-Corp (non-passive activity)Retail Business w/ $100k of

Taxable Income

Building, LLC (Passive activity)w/ $100k losses

from Cost Seg


Grouping Election

Grouping election allows you to use income or losses between the two entities that are grouped.

Result = Taxpayers S-Corp income is offset by the LLC losses. Tax = $0. Both entities must be 100% owned by the same people and the grouping election is made in the first tax year those entities co-exist.

Taxpayer

S-Corp (non-passive activity)Retail Business w/ $100k of

Taxable Income

Building, LLC (Passive activity)w/ $100k losses

from Cost Seg

Cost Segregation Estate Planning Strategy

When a building owner dies and a property is inherited, any gains built up during the decedent’s life are forgiven.

Beneficiary receives a “step up,” which means the property’s tax basis is reset to fair market value on the date of death and depreciation starts all over.

This provides an opportunity to apply a cost segregation study on the decedent’s pre-stepped up basis creating a permanent tax deduction.

DECEDENT’S GAIN FORGIVEN

DECEDENT’S TAX RETURN

Date of Death(August 2015)

HEIR’S TAX RETURN

$2M FAIR MARKET VALUE

$1M INITIAL INVESTMENTAPARTMENT

$728K Undepreciated

$1.27M Gain Forgiven

Purchase Date(2008)

TIME

Date of Death2015


Most CPAs already know this is a great candidate for Cost Segregation

$1M INITIAL INVESTMENT

$728K Undepreciated Basis

2008 Purchase Date

But it’s the original pre-stepped up undepreciated basis that has the most value

HEIR STARTS DEPRECIATION OVER

CASE STUDY 1

FAIR MARKET VALUE $3M

Cost Segregation on original pre-stepped up basis

DOD - August 2015. Must file tax return for income generated Jan thru Aug 2015.

Cost Seg done and Form 3115 filed:Generates $174,000 catch up deduction (Sec. 481(a)).

Aug 2015Heir’s Tax Return

INITIAL INVESTMENT

$554K Undepreciated BasisWith Cost Segregation

2015 Tax Return Jan thru AugDescendant’s Tax Return

TIME

$728K$174K

CASE STUDY 1Cost Segregation on original pre-stepped up basis

Permanent Tax Savings of $68,904 ($174k x 39.6% tax rate)

Must be done on final tax return of decedent

Aug 2015Heir’s Tax Return

2015 Tax Return Jan thru AugDescendant’s Tax Return

TIME


INITIAL INVESTMENT

$554K Undepreciated BasisWith Cost Segregation


If a buyer and seller agree in the Purchase and Sale Agreement (PSA) to allocate value to the personal property and building improvements, a cost segregation study might be voided.• Talk to a Cost Segregation expert

Cost Segregation Audit Techniques Guide Updated in 2016 • Cost Segregation ATG

Qualified Improvement Property Rules for 2016 and forward

Cost Segregation Developments and Considerations

https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents


Qualified Improvement Property (QIP) - available to more taxpayers than Qualified Leasehold Improvements (QLHI).

QIP is any improvement to an interior portion of a building that is nonresidential real property as long as it is placed in service after the building was first placed in service (by any taxpayer).

Excludes costs for enlarging a building, any elevator or escalator, or the internal structural framework of the building.

Works for owner occupied buildings!

39-year recovery period, bonus-eligible, no ‘3-year’ rule, no lease requirement.

For property placed in service after December 31, 2015.

Opportunities under the PATH Act: Qualified Improvement Property

Tax Credits · Incentives · Cost Recovery | Nationwide Service | © KBKG inc 2014

New rules say you can now take a loss deduction when you remove components from your building!

Example: If you pay $50,000 for all new HVAC units in your building, you need to capitalize that amount. Depreciate that $50,000 over 39 years Figure out how much the old HVAC was not written off and claim all that

as an immediate deduction!

Can do this on a go forward basis

Retirements and Dispositions


Example: Taxpayer acquired $5M building 3 years ago.

This year they spent $1M to remodel portion of 2nd floor (ceilings, walls, lighting, plumbing, ducting, electrical wiring, etc.)

We determine the original cost of demolished components is $470K (from the original $5M building)

Recognize a loss of $430K on current tax return (original cost basis less depreciation already taken)

Retirement of Structural Components


Retirements Convert Recapture tax into Capital Gains

If you incorrectly continue to depreciate 1245 and 1250 property that was removed from a building, you pay recapture tax upon sale

1245 recapture is at ordinary rates (35%-41%) 1250 recaptured at 25% Capital Gains are typically taxed at 20%

Retirements createPermanent Tax Savings!!


Previous example – $5M building with $470K of retirements. If they continue to depreciate the $470K, they recapture all of it upon

sale Let’s say $370K of that was 39 year and $100K was 7 year property Recapture Tax = $127,500 ($370K X 25% + $100K X 35%)

If they did a retirement study Recapture tax on the $470K = 0 Capital gain tax = $94,000 ($470K X 20%)

Permanent tax savings of $33,500 upon sale

Retirements createPermanent Tax Savings!!


Final Disposition Regulations:

Can use a cost segregation study Can discount the cost of a replacement component to its placed-in-service

year using the Producer Price Index (PPI) • Can be used for restorations but PPI can not for betterments or

adaptations.

Use KBKG Partial Disposition Calculator• http://kbkg.com/solutions/partial-disposition-calculator

Determining the Basis of Removed Building Component.

http://www.kbkg.com/ppi-search-tool

http://www.kbkg.com/ppi-search-tool

http://kbkg.com/solutions/partial-disposition-calculator


Rules that clarify when expenditures can be deducted as repair and maintenance expenses vs. capitalized and depreciated.

Made effective for 2014 and forward Generally taxpayer friendly Provide opportunities for taxpayers to claim missed repair deductions Review tax depreciation schedules

Tangible Property Repair Regs


IRS Notice 2017-6 extended timeline to claim missed repair deductions on 2016 tax returns

2016 IRS Audit Techniques Guide for the Capitalization of Tangible Property

Rev. Proc. 2015 56 - Safe harbor for retail or restaurant establishments ‐ Determining if “remodel” or “refresh” can be expensed

Tangible Property Regs Updates


An “improvement” is defined under §1.263(a)-3(d) as an amount paid after the property is placed in service which:

1. Is a Betterment to the UOP

2. Adapts the UOP to a new or different use

3. Restores the UOP

B-A-R = Improvement (Capitalize)

What is an “Improvement?”


Asbestos removal (after building was purchased) not a betterment. At time of purchasing Assisted Living Facility, client knows it needs work.

Right after purchase & for a period of 2 years, while operating the facility, client pays for extensive repairs to bring facility to higher quality condition. Ameliorates a previous material condition and is a betterment

Costs to reconfigure and paint a retail store to update the look were not a betterment

Not Betterment - Replace wooden shingles that are no longer available with comparable asphalt shingles that are stronger than wooden shingles. (Technological Advances)

Betterment - Replace same shingles with lightweight composite shingles that are maintenance-free, a 50-year warranty and Class A fire rating

“Betterment?” Examples


Restoration only if:

Replacement of major component or substantial structural part Returns UOP to ordinary operating condition – if in state of disrepair &

no longer functional Rebuilds UOP to like-new condition after end of class life

Class life - alternative depreciation system Replaces component deducted as loss; or adjusted basis taken into

account for loss/gain Repair component after casualty loss/event if basis adjusted

What is a “Restoration?” 1.263(a)-3(k)


Restoration rule must be applied to all major components of the building or UOP Must first identify the major component of a building system. Then see

if a significant portion was replaced.

Example: Office building HVAC System comprised of 3 furnaces, 3 AC units, and duct work throughout the building

1 Furnace breaks down, replaced with a new furnace 3 furnaces together perform critical function for HVAC system. 3 Furnaces = Major Component However replacing a single furnace (1/3) is not a significant portion of

the major component. Not a restoration

Restoration


See KBKG Repairs Decision Tree and Major Component Chart http://kbkg.com/handouts/KBKG-repairs-decision-tree.pdf

Partial Disposition Calculator http://kbkg.com/solutions/partial-disposition-calculator

Resources

http://kbkg.com/handouts/KBKG-repairs-decision-tree.pdf

http://kbkg.com/solutions/partial-disposition-calculator


Resources


Resources


Expense if you reasonably expect (at time placed in service) to perform more than once during class life (alternative depreciation system) Does not apply to Betterments, Adaptations

FOR BUILDINGS: must reasonably expect to perform more than once during the ten year period from purchase. Ex. Expense - Every 5 years the escalator hand rails are replaced

KBKG Commentary: It can fail safe harbor and still be considered an expense! Ex. Every 12 years we replace HVAC unit. Fails Safe Harbor but can still

satisfy the BAR standards.

Routine Maintenance Safe Harbor


Parking Lot Resurfacing

Apply the Routine Maintenance Safe Harbor

NATIONWIDE SERVICE Tax Credits · Incentives · Cost Recovery © KBKG inc 2012

Taxpayer with an Applicable Financial Statement (AFS) $5,000 expensing threshold per item or invoice for property Must have written expensing policy stating such & treat amounts

consistently for book

Taxpayer without Applicable Financial Statement (AFS) $2500 expense threshold per item or invoice

Can not split costs among multiple invoices

Example – newly constructed office building with several appliances in break rooms each under $2,500. (Expense)

De minimis Rule ExpensingSafe Harbor

http://www.kbkg.com/


Old Rule: Removal costs of an asset component needed to be capitalized with the new component.

New Rule: Removal Costs of an asset component can be deducted if taxpayer realizes gain/loss on old component for tax.

Example: Landlord owns commercial building and pays $500K for tenant improvements in year 1. In year 5, tenant leaves and new tenant requires landlord to gut and

renovate the space costing $600K Contractor cost detail shows $50K “demolition” cost to remove old

improvements Landlord can expense the $50K demolition costs and deduct remaining

portion of $500K cost for the old tenant.

Removal Costs / Demolition


Cost Segregation and New Developments

39-year

5-year

39-year

7-year

15-yearCost Seg


Should review all fixed assets (not just buildings) to identify opportunities to accelerate depreciation deductions, retire old assets, correct miscapitalized repair and maintenance expenses, missed bonus depreciation, etc.

Cost Segregation and New Developments

39-year

Repairs

5-year

Roof Windows Doors Lighting Plumbing Electrical

7-year15-year

Cost Seg

Demo Expense

Bonus Rate by Asset Group

Retirements

IRC 48 Property

Security Elevators Gas Distr. HVAC Ceilings Floors

39-year

How much is it worth?

Additional year 1 deductions of 15% - 40% of new structural renovation costs (on top of benefits from cost segregation reclassifications).

Example: Client spends $3M for structural renovations.

Additional year 1 deductions =$450K - $1.2 M

COPYRIGHT KBKG INC 2012

REPAIR VS. CAPITALIZATION REGS.

New rules Allow a retirement loss on structural components

removed from a building Clarify repair expense treatment of many types of

building costs such as HVAC or roof replacementsGood Candidates

Retirements Any building, owned more than 1 year, that then

goes through renovations (>$300k). Building should have at least $1M of remaining

depreciable basis left.Repairs

Incurred significant costs for building items such as roof work, HVAC, windows, lighting, plumbing, ceiling, drywall, flooring, etc. (>$300k).

COST SEGREGATION

Accelerate depreciation deductions for real property by reclassifying building components into shorter tax lives.

Any kind of real estate Constructed Purchased

Good Candidates Any building with over $750K of depreciable tax basis Any leasehold improvement with over $500K of

depreciable tax basis

COPYRIGHT KBKG INC 2014

Expanded Remodeled

How Much is it Worth?

Net present value = 3-6% of total building cost

Example: $2M office building Net Present Value of $60K -$120K

Basis Step Up 1031 Exchanges

Questions?Gian Pazzia

• KBKG• Principal• CCSP• [email protected]

Mark Heath• McKonly & Asbury• Partner• CPA• [email protected]