Tag Archives: Cost Segregation

Though cost segregation is a very popular tax savings strategy, some aspects are seldom encountered in practice. One rarely encountered situation is the proper reclassification of what looks like a building to tangible personal property. From a tax perspective, reclassifying an apparent building to short-life tangible personal property has substantial, immediate cash tax benefits. These opportunities are most commonly found at heavy manufacturing facilities and typically depend on a building-like structure functioning as large piece of machinery or equipment.

Most manufacturing industries are assigned a seven-year tax recovery period for their tangible personal property. For each million dollars of basis, reclassifying a structure from 39-year nonresidential real estate to seven-year tangible personal property results in additional first-year tax deductions of approximately $550,000 after taking into account 50% bonus depreciation and the much shorter recovery period. Assuming a 40% tax rate, this means first year cash savings of approximately $220,000. To understand how it is possible to reclassify an entire “building” to tangible personal property, an understanding of the former Investment Tax Credit is necessary.

The former Investment Tax Credit (“ITC”) was a tax credit for the construction or acquisition of most tangible personal property and certain other tangible property, not including buildings and their structural components, used as an integral part of certain industries, such as manufacturing. (The former ITC rules still govern MACRS property classifications to a large extent.) The meaning of the former ITC regulations and rules were very frequently litigated. Over the course of many years, the courts developed many tests to determine whether a structure was a building, other tangible property, or tangible personal property.

The two primary tests to identify a building were: 1) the appearance test and, 2) the function test. In practice, the courts primarily looked to the function test. This test looked to whether human activity in a structure was minimal or incidental to the functioning of the structure as part of the manufacturing process. For example, an automated, deep freeze storage warehouse may have minimal human activity relative to the primary function of freezing food products. In such cases, human activity may be limited to only routine maintenance. In the manufacturing context, the Tax Court expanded this logic to facilities such as heavy craneway structures in the Lukens case in 1987.

In Lukens, the Tax Court held that a steel foundry’s craneway structures were essentially an item of machinery or equipment. A craneway structure consists of elevated rails along which a crane moves. The cranes transport heavy materials through a production process. In Lukens, the craneways had roof coverings and siding that functioned as walls for the cranes. The structures had no offices, restrooms, heating or air conditioning for employee comfort. The structures were designed to support the cranes as well as the rudimentary roof. Another way of looking at Lukens is that the structure of the crane also, incidentally, supported the roof and siding and that the roof and siding were necessary to protect the cranes and only incidentally protected the workers. Since all human activity was incidental to the production process and the structures functioned as a giant piece of machinery, the Tax Court held that they were not buildings, but rather tangible personal property. This was so even though they looked like buildings with roofs and some walls.

The facts and circumstances for applying Lukens are very specific and may easily be misinterpreted. Certain types of structures, such as parking garages, are specifically defined as buildings though some taxpayers have unsuccessfully attempted to argue otherwise. If you or your clients have heavy manufacturing facilities or automated facilities with minimal worker accommodations, please contact us to discuss a cost segregation study to determine whether the entire facility qualifies as short-life property.

Full Lukens Case Document

For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting.  For more information, please call 800.806.7626 or visit www.sourcehovtax.com.

From Federal Tax Updates Checkpoint Newsstand May 31, 2011

Businesses that trade in machinery or equipment for which they claimed bonus depreciation under Code Sec. 168(k) may qualify for another bonus depreciation deduction on the remaining depreciable basis if they swap for like-kind property that also is eligible under Code Sec. 168(k). In effect, the business gets two bonus depreciation deductions for its expenditure on the traded-in property. What’s more, this result is explicitly OK’d by the regs.

Background. Bonus first-year depreciation deductions are available for a property if: (1) it is property to which the modified accelerated cost recovery system (MACRS) rules apply with a recovery period of 20 years or less, computer software other than computer software covered by Code Sec. 197, qualified leasehold improvement property, or certain water utility property); (2) its original use commences with the taxpayer; and (3) it is timely bought and placed in service by the taxpayer.

The bonus first-year depreciation allowance is:

• 50% of the cost of qualified property acquired and placed in service after Dec. 31, 2007, and before Sept. 9, 2010;
• 100% of the cost of qualified property acquired and placed in service after Sept. 8, 2010 and before Jan. 1, 2012 (before Jan. 1, 2013 for certain longer-lived and transportation property); and
• 50% of the cost of qualified property acquired and placed in service after Dec. 31, 2011 and before Jan. 1, 2013 (after Dec. 31, 2012 and before Jan. 1, 2014 for certain longer-lived and transportation property). (Code Sec. 168(k)(2), Code Sec. 168(k)(5))

Note that 50% bonus depreciation also applied for certain qualified property acquired after May 5, 2003 and before Jan. 1, 2005, and 30% bonus depreciation applied for certain qualified property acquired after Sept. 10, 2001, and before May 6, 2003.

MACRS property may be acquired (1) in exchange for MACRS property in a Code Sec. 1031 like-kind property exchange, or (2) to replace involuntarily converted MACRS property in a Code Sec. 1033 involuntary conversion. (Reg. § 1.168(i)-6(c)(1)) The replacement property is for depreciation purposes divided into the depreciable exchanged basis (i.e., remaining basis of the relinquished property carried over to the replacement property), and the depreciable excess basis (i.e., additional consideration to acquire the replacement property). Where the properties share the same recovery class and depreciation method, the depreciable exchanged basis is written off over what’s left of the relinquished property’s recovery period; and the depreciable excess basis is in effect treated as a separate property with a recovery period that begins anew. (Reg. § 1.168(i)-6(c)(3)(ii))

Double helping on bonus depreciation. When otherwise eligible MACRS property or computer software is acquired via a Code Sec. 1031 like-kind exchange or as a result of a Code Sec. 1033 involuntary conversion, both the carryover basis and the excess basis, if any, of the acquired property are eligible for bonus depreciation. (Reg. § 1.168(k)-1(f)(5)(iii)(A)) What’s more, it doesn’t matter if bonus depreciation was claimed on the old property. (Reg. § 1.168(k)-1(f)(5)(vi), Ex. 3)

RIA illustration: In January of 2010, ABX Corp. bought a new refrigerator truck (5-year MACRS property) for $100,000 and placed it in service that year. In 2011, ABX acquires another new, higher-capacity refrigerator truck in exchange for the truck bought in 2010 by trading in that truck and paying $50,000 cash. ABX uses the optional rate tables to compute depreciation and is subject to the half-year convention in 2010 and 2011.

For 2010, ABX claimed 50% bonus first-year depreciation for the truck bought and placed in service that year. As a result, its 2010 depreciation deduction for the truck was $50,000 of bonus depreciation (.50 × $100,000) plus $10,000 of regular first-year depreciation allowance (.20 recovery year one table percentage for 5-year property × [$100,000 − $50,000 bonus depreciation]), for a total of $60,000.

For 2011, ABX claims an $8,000 depreciation deduction (.32 recovery year two table percentage for 5-year property × [$100,000 − $50,000 bonus depreciation] × 6/12 [half-year convention applies]) for the relinquished truck.

ABX may claim a 100% bonus first-year depreciation deduction for the $32,000 remaining depreciable basis of the relinquished truck, i.e., the depreciable exchanged basis ($100,000 cost − $60,000 − $8,000). ABX also may claim a 100% bonus first-year depreciation deduction for the $50,000 in cash that it pays to acquire the upgraded refrigerator truck.

RIA observation: In essence, for bonus depreciation purposes, the regs treat a taxpayer like ABX as if it had sold the old truck for its remaining depreciable basis and then used the proceeds, along with additional cash, to purchase a new one.

RIA caution: This won’t work if the older-model truck was acquired in January of this year and the newer model in December. Under Reg. § 1.168(k)-1(f)(5)(iii)(B), bonus depreciation isn’t allowable for the exchanged (or involuntarily converted) MACRS property if the exchanged (or involuntarily converted property) is placed in service and disposed of in a like-kind exchange or involuntary conversion in the same tax year.

If you plan to expand your business, 2011 is a great time to invest in new equipment or building assets and benefit from newly expanded tax incentives. In his state of the union speech, President Obama highlighted the recently passed Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 signed into law December 17, 2010. As he said “Thanks to the tax cuts we passed, Americans’ paychecks are a little bigger today. Every business can write off the full cost of new investments they make this year.”

For businesses with projects that qualify for tax incentives such as cost segregation, the benefits for 2011 will be substantial. A taxpayer must meet specific requirements to utilize this tax deduction. Qualifying property generally includes: depreciable property with a recovery period of 20 years or less; water utility property; computer software; and qualified leasehold improvements. A cost segregation analysis is a method of identifying the maximum amount of qualifying property (property with a recovery period of 20 years or less) and separating those costs from the real property assets associated with a new building or expansion project.

Also, included in the tax relief act is a two-year extension of the 50 percent, first-year additional bonus depreciation allowance which applies to qualifying property acquired by a taxpayer from January 1, 2008 through December 31, 2012, and placed in service before January 1, 2013. The bonus depreciation rate increases from 50 percent to 100 percent in the case of qualifying property acquired after September 8, 2010, but before January 1, 2012, and placed in service before January 1, 2012.

When I first began working in the area of cost segregation, people would ask, “What do you do for a living?” I would respond, “I explain to people what I do for a living, because no one has ever heard of it.” At the time only the large accounting firms provided this service.

Over the past decade, however, the cost segregation market has spread to small and medium sized investors and businesses. Despite the rapid growth of service providers nationwide, there are still underserved businesses and markets.

Building owners who acquired or built commercial buildings in prior years are often overlooked. There is a common misconception that only new construction qualifies for the benefit of cost segregation. However, anytime a building is built or changes hands, depreciation starts over, and a study can be performed. Cost segregation front-end loads that depreciation, so the owner recoups money faster.

When looking at buildings placed in service in prior years, the missed depreciation gets caught up on the tax return in the year of the study via a change in method of accounting (Form 3115) and a §481(a) adjustment.

For example, if you purchased a building in 2000 for $5 million and put it on the books as 39-year property, the straight-line depreciation would yield an annual deduction of $128,000. Through a cost segregation study, we reclassify 12% in 5-year and 8% in 15-year property. Because of the §481(a) adjustment, the additional current year deduction (above and beyond the depreciation already taken) would be $624,500, which would result in a current year cash flow increase of $218,575. The net present value over the entire tax life of the building is $149,110.

Due to the Tax Reform Act of 1986, we can conduct a cost segregation study for any commercial or rental building, constructed or acquired, since January 1, 1987. Ideal properties are those built or acquired in the last 15 years, but many good opportunities exist back to 1987.

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Credit markets – where day-to-day borrowing occurs to keep the gears of the economy turning – are still stuck. Even relatively healthy businesses are being left out in the cold. Businesses can’t get funding for supplies and in some cases are falling behind on their payrolls.

And companies in search of cash are looking to tax strategies for help.

So, how can businesses find ways for needed cash to buy inventory, finance payables, or fund payroll?

Focus On Opportunities:
Here are 4 tax tools that can make a significant difference. Read More →

After a couple all-nighters in Washington and some premature atta boys, we’re right back where we were a couple of weeks ago, after Lehman Brothers declared bankruptcy and the government lent AIG $85 billion.

But there are still strategies to help businesses pay less tax and get more cash. Read More →

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Tax planning is a year-round event if you want to minimize your business’s tax bill. These strategies can help reduce your tax obligations and increase cash flow. Read More →

The country came very close to a complete financial meltdown last week. We’re not out of the woods yet.

So, what does this mean for you and your business or if you are a CPA, your clients if you need cash to buy inventory, finance payables, or fund payroll?

Focus On Opportunities:
Here are four proven ways businesses can increase cash flow. Read More →

The Internal Revenue Service has released a list of industry-specific issues that its auditors may consider when examining a business’s returns.

The IRS is looking at cost segregation studies of whether an asset is Section 1250 property (which generally has a 39-year recovery period) or Section 1245 property (generally a five- or seven-year recovery period). The IRS said there has been an increase in claims reclassifying Section 1250 property as Section 1245 property. The issue affects various industries, including retailers, food, pharmaceuticals, and healthcare.

About SourceCorp:
Celebrating our 25th year in business, SourceCorp Professional Services provides Energy Efficient Commercial Tax Deduction Certification, LIFO Accounting, R&D Tax Credit Studies, Bonus Depreciation, and Cost Segregation Studies. With a team of nearly 70 professionals and with offices located throughout the country, SourceCorp helps clients realize unparalleled experience, services, and trust. SourceCorp serves many of the nation’s most prominent CPA firms, Associations, and Fortune 1000 companies. For more information, please call 817.732.5494 or visit www.SourceCorpTax.com.

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