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What is
Cost Segregation?
 Most
owners of residential rental property depreciate the entire cost of their
building over 27.5 years. Owners of commercial real estate, such as office
buildings, retail space, restaurants, warehouses and manufacturing plants
often depreciate the entire cost using 39-year or 31.5 year depreciation
periods, depending on the date of acquisition. Under IRS cost segregation
guidelines, however, a significant portion of a building's cost can be
depreciated over much shorter periods, usually 5 or 7 years.
The crux of cost segregation is determining
whether an asset can be classified as "Section 1245 property" and
subject to a shorter cost recovery period (e.g. 5 or 7 years) or
"Section 1250 property" and subject to a longer cost recovery
period (e.g. 39 or 31.5 or 27.5 years). The difference in recovery periods
as far as allocating costs has placed the IRS and taxpayers in adversarial
positions for purposes of calculating depreciation deductions. Another
incentive for allocating costs to shorter recovery period property is the
expensing provisions of Code Section 179, which applies to qualifying
tangible personal property.
The IRS has released cost segregation audit
techniques which provides tax practitioners a guide for advising clients on
what a cost segregation study must include in order to prevent future audit
adjustments. Therefore, whether acquired or constructed, property must be
segregated into individual components or asset groups having the same
recovery periods and placed-in- service dates in order to properly compute
depreciation. This may be simple when the actual cost of each individual
component is available. However, when only lump-sum costs are available,
cost estimating techniques are often required to segregate or allocate
costs to land, land improvements, buildings, equipment, furniture and
fixtures. These cost estimating techniques are often called a cost
segregation study or cost segregation analysis.
To be effective against IRS scrutiny, a cost
segregation study must be prepared by an experienced cost segregation firm
that has knowledge of both the construction process and the tax law
involving property classficiation for depreciation purposes. Often, such
firms will employ engineers, architects, lawyers, etc. and work closely
with tax attorneys. In the end, the final determination is factually
intensive and must be supported by heavily detailed corroborating evidence.
However, if properly done, there is an opportunity for extensive tax
savings. We have worked closely with cost segregation firms, occasionally
resulting in restatement/amendment of prior year tax returns.
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Greetings!
This October issue was delayed in order to include the
provisions of two new tax bills: the Working Families Tax Relief Act of
2004 signed into law last week and the American Jobs Creation Act of 2004
passed by the House and Senate as of October 11th and expected to be
signed into law by the President within the next few days. Both are
filled with goodies for everyone--almost $300 billion worth--how it is to
be paid for is anyone's guess.
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· Working
Families Tax Relief Act of 2004
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 While many of the
tax changes affect 2005 and later years, several important provisions
affect 2004 tax returns. The new law's focus is on four accelerated tax
cuts from the 2001 and 2003 Tax Acts scheduled to expire on December 31,
2004 and a package of regularly expiring business tax provisions that had
expried on Decmeber 31, 2003. Several new provisions are also included;
most prominently, a new uniform definition of a "child" to be
applied throughout the Tax Code.
The
following is a summary of the new law. For individual taxpayers: (1) the
child tax credit remains at $1,000 per qualifying child for 2004 through
2009; it was scheduled to be $700 for 2005-2008, $800 for 2009 and reach
$1,000 in 2010; (2) full marriage penalty relief in 2005-2008 for basic
standard deduction; thus, for 2005-2008, the basic standard deduction for
married joint filers is increased to double the standard deduction for
single taxpayers; (3) the expanded 10% tax bracket is now effective
through 2010; (4) no rollback in the 2005 alternative minimum exemption
for individuals; for 2005, the AMT exemption is increased to $58,000 for
married taxpayers filing jointly and to $40,250 for unmarried
individuals. Previously, such thresholds had been scheduled to decrease
to pre-2004 levels. (5) the provision allowing the combined total of
nonrefundable personal tax credits (e.g. dependent care credit, child tax
credit, Hope and Lifetime Learning credits, credit for the elderly, etc.)
to the full extent of regular and AMT liability is extended to the 2004
and 2005 tax years; (6) teacher's classroom expense deduction provision
is extended to the 2004 and 2005 tax years; (7) for years beginning after
2004, the Act establishes a uniform definition of qualifying child for
purposes of the dependency deduction, child tax credit, earned income
credit, the dependent care credit and head of household filing status.
Under this uniform definition, in general, a child is a qualifying child
of the taxpayer if the child satisifies each of three tests: (a)
residency test, (b) relationship test, and (c) age test. This is welcome
news for those trying to navigate their way through the various
definitions of a "child" under different provisions of the
Code. For businesses: (1) the research and development tax credit is
extended for amounts paid after June 30, 2004 and before 2006; (2) the enhanced
deduction for charitable contributions of qualified computers is extended
for contributions made in tax years beginning after 2003 and before 2006;
(3) the welfare-to-work and work opportunity tax credits are extended for
wages paid to qualified individuals starting work after 2003 and before
2006. According to the White House, this Tax Act will lower the tax bill
for 94 million families with children.
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· American Jobs
Creation Act of 2004
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On the heels of a massive tax bill aimed at cutting the
taxes for millions of families, Congress has passed another huge tax bill
that includes hundreds of business tax breaks, which are supposed to be
subsidized by the elimination of certain tax shelters and the imposition
of new custom duties.
The
impetus for this legislation was the World Trade Organization's ruling
that the exclusion for extraterritorial income (ETI) for export companies
was an illegal export subsidy. However, this Act goes far beyond
addressing this and creates billions of dollars of new tax breaks. Some
of the provisions include: (1) For transactions after 2004, the Act
repeals the ETI system of tax benefits and provides a 9% deduction (equal
to a 3% rate cut) on all manufacturing (and certain domestic production)
activity undertaken in the US, whether it is exported or not. This
deduction is available to C corporations, S corporations, partnerships,
sole proprietorships, and estates and trusts. It is also allowed for AMT
purposes. The deduction is phased in over five years: 3% in 2005-2006, 6%
for 2007-2009, 9% after 2009; (2) The Act also extends for an additional
two years the increased amounts that a taxpayer may expense under Code
Sec. 179 ($100,000 indexed for inflation) for equipment purchases; (3)
For tax years after 2004, family members may elect to be treated as one
shareholder for purposes of determing the number of shareholders of an S
corporation and increases the maximum number of S corporation
shareholders from 75 to 100; (4) For tax years beginning in 2004, suspended
losses can be transferred with transfers of S corporation stock to a
spouse or former spouse incident to divorce; (5) For tax years beginning
after 2004, the Act repeals the 90% limitation on the use of foreign tax
credits against AMT; (6) Excess foreign tax credits may be carried
forward for 10 years instead of 5 years to any tax years ending after the
enactment date of the Act; (7) For 2004 and 2005, taxpayers are allowed
to deduct state and local sales taxes instead of state income taxes.
Taxpayers may deduct their actual sales taxes or use IRS-published
tables. These are just a handful of the hundreds of tax law changes. The
breadth and effect of the new provisions is staggering. We are available
to assist you with appropriate planning strategies associated with these
changes.
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· The October
15th Deadline
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The final, final extension deadline for filing personal
income tax returns, partnership/LLC tax returns and trust and estate (calendar
year) fiduciary income tax returns has just about arrived. To avoid late
filing penalties, make sure to have all returns postmarked no later than
Friday the 15th--even if it means spending your Friday evening at the
post office!
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