Franchise Times

Cost segregation
Use IRS to help fund operations and growth

Imagine being able to offer your franchisees the opportunity to obtain large long-term, no-interest loans to invest in their businesses, without any risk or major investment on your part. Sound too good to be true? Read on. . .

Franchisors such as hotels, restaurants, auto services and others whose businesses involve real estate holdings are beginning to discover what large commercial property owners have known for several years—that a little-known, widely misunderstood, and IRS-approved tax strategy called cost segregation can enable commercial property owners to defer tens of thousands or even hundreds of thousands of dollars in income taxes.

Cost segregation came into being in 1997, with the landmark tax court case, Hospital Corporation of America (HCA) v. IRS 109 TC 21 (1997). Prior to that ruling, the cost of commercial buildings had to be depreciated over 39 years, regardless of the building type or use. With cost segregation, owners can accelerate the depreciation of qualified non-structural building components into more appropriate timeframes such as five, seven, and 15 years. The result is significant tax savings: The owner of a $1.0 million building could see as much as $150,000 in added bottom line cash flow.
In spite of its value, most building owners have never heard of cost segregation. Many others have only a vague notion of what it is, and little idea of its benefits. Nor has the IRS tried to make taxpayers aware of the ruling. As we all know, the IRS is not in the business of telling taxpayers how to pay the least amount of tax possible.
Although many CPAs have heard about cost segregation, relatively few have suggested it to their clients. One reason is the IRS wants a type of engineering expertise that is rare within the CPA community. Also, until recently cost segregation studies were prohibitively expensive for all but the largest commercial property owners. Over time, a small number of providers have managed to bring fees within reach of owners of smaller properties. As a result, the engineered cost segregation study is slowly beginning to catch on, albeit slowly.

A few visionary franchisors are learning that by making information about cost segregation available to their existing and prospective franchisees, they can increase franchisee profitability and perhaps wind up with another location or several. Franchisors who own properties themselves can also realize direct benefits.

How does it work?
In order to take advantage of the IRS ruling, an owner must engage and apply an engineered cost segregation study. This is the process of identifying the building components that qualify for accelerated depreciation. Depending on the type of building and its use, anywhere from 20 percent to 50 percent or more of the purchase, construction or leasehold improvement cost can be accelerated. Types of assets that can be reclassified include portions of electrical, plumbing and mechanical systems and numerous other components. For existing buildings, the owner’s accountant submits a form 3115 with the next tax return documenting the change in accounting method. Any accrued benefit is taken immediately, without having to amend previous years’ returns.

The process of performing a cost segregation study is highly technical, and there are no bright line tests for what components can be accelerated. Internal IRS directives make it clear that only those with expertise in the various aspects of commercial construction are qualified to properly identify components and to determine what depreciable life is appropriate for a given component. The required expertise outlined by the IRS includes understanding construction methods and systems, reading blueprints and engineered drawings, and knowing the relevant court cases and private letter IRS rulings. This skill set is a blend of engineering, legal, and specialized tax expertise. For these reasons, owners are strongly encouraged to seek out a firm that specializes in engineered cost segregation studies and that meets all the necessary qualifications.

Who can benefit?
The IRS ruling applies to anyone who purchased, constructed, renovated or made substantial improvements to a commercial building after 1986. Those who did so within the last 10 years have the most to gain. Thanks to a 1999 provision of the code, depreciation that should have been allocated in previous years can be taken as an all-at-once deduction on current-year taxes, providing an immediate boost in cash flow.

As an example, consider an owner who purchased a commercial property on January 1, 2005, for $1.25 million with a land value of $250,000. The building’s value of $1 million would typically be depreciated using a 39-year straight line method, allowing the owner to depreciate 1/39th of the building’s value, or $25,641 per year. If the owner is in a 33 percent tax bracket, as of January 1, 2007, their tax bill has been reduced by $8,461 per year, for a total of $16,923 so far.

Suppose, however, that in 2007 the owner engages and applies an engineered cost segregation study in which 40 percent of the building components—many of which are literally in the walls—are identified and more appropriately depreciated over five-, seven-, and 15-year time frames, with the balance depreciated over the standard 39-year period. The owner can now depreciate $107,226 per year for the first 5 years, as opposed to $25,641—or $81,585 in additional depreciation each of the first 5 years. As a result, the owner’s cumulative after-tax benefit as of January 1, 2007, is $70,769 (see table). The owner’s accountant applies all of the difference to the current year tax without amending prior returns, leaving $53,846 that can be invested back into the business now. Over the following three years the owner will realize an additional $26, 923 per year in after-tax benefits (see chart).

For franchisees who don’t yet own their buildings but would like to, an engineered cost segregation study can improve a financial profile, making it easier to obtain financing or procure better terms.
The IRS now considers cost segregation to be the correct method for depreciating a commercial property. Franchisors and franchisees, whether they are individuals, ‘C’ corporations or LLCs, who own— or would like to own—their buildings may well want to consider an engineered cost segregation study. The result could be a significant and immediate increase in cash flow and tax savings.