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New Guidance Encourages Cost Segregation Studies

By Michael Greenwald and Randy Schwartzman

Tax practitioners may want to encourage their clients to consider having a cost segregation study performed if they recently acquired or made significant leasehold improvements to a new building, warehouse or other property, or if they acquired or made significant leasehold improvements to their property in the past.

A cost segregation study is an analysis by accounting, engineering and real estate professionals, such as those on the staffs of public accounting firms, who work hand in hand with clients to use such studies to accelerate the federal and state tax depreciation to be claimed on property acquisitions or improvements.

The primary goal of these studies is to identify all property that qualifies for shorter depreciable lives—for example, 5, 7 or 15 years as opposed to the 27.5 years or 39 years required for residential or commercial property, respectively.

The direct benefit of the analysis is increased depreciation deductions in the early years of the useful life of a property that result in substantially increased tax savings and more cash available for other uses. A recent tax law change compounded this benefit by allowing up to 50 percent first-year bonus depreciation on qualifying 5-, 7- or 15-year properties. Such bonus depreciation is not allowable for 27.5- or 39-year properties.

If taxpayers used catch-up depreciation for past acquisitions, issues always existed as to whether the catch-up depreciation would be available, and, if so, whether or not it would be considered a change in method of accounting. The end of 2003 brought about a welcomed resolution to the lingering uncertainty.

The Treasury Department last December issued final regulations making clear that most changes in accounting for the depreciation of property will be treated as changes in method of accounting. These new regulations affect taxpayers who wish to make changes to their accounting for depreciable assets that have not taken advantage of the more beneficial depreciation rules in the past.

The new regulations provide that a change in recovery period specifically assigned by published Internal Revenue Service guidance is a change in method of accounting. In addition, the regulations state that a change in depreciation method or convention is a change in method of accounting. The regulations also provide that a change in the treatment of an asset from nondepreciable or nonamortizable to depreciable or amortizable, or vice versa, is a change in method of accounting.

Accordingly, changes to correct the depreciation of Modified Accelerated Cost Recovery System assets as a result of a cost segregation study are made by filing a Form 3115 with the taxpayer’s tax return for the year of change and filing a copy of the Form 3115 with the IRS National Office. The adjustment (i.e., the difference between the depreciation deducted for the asset in prior years using the impermissible method of depreciation and the depreciation that would have been allowed under a permissible method) is recognized entirely in the year of change if the adjustment involves understated depreciation.

New Revenue Procedure Helps

Concurrent with the new regulations, the Service issued a Revenue Procedure, Rev. Proc. 2004-11, which permits taxpayers to make a change in method of accounting for depreciable or amortizable property after the actual disposition of the property. Previously, changes in method of accounting for depreciation had to be made while the taxpayer still owned the asset. Now, a change in depreciation method can be made until the statute of limitations expires for the taxable year in which the asset was disposed.

The IRS’ new procedure makes another alteration that may be helpful for some taxpayers changing their depreciation methods pursuant to a cost segregation study. Taxpayers will now be able to file a Form 3115 and recognize an immediate adjustment even if the erroneous depreciation method has been used on only one tax return. Taxpayers in this situation still have the option, however, of filing an amended tax return instead of filing a Form 3115.

Finally, Rev. Proc. 2004-11 states that a taxpayer who has acquired property in certain carryover basis transactions (e.g., mergers, transfers to a controlled corporation or partnership, and transfers between members of a consolidated group) can file a Form 3115 to change an impermissible depreciation method adopted by the prior owner of the property. In that case, the adjustment includes all necessary adjustments since the property’s placed-in-service date by the prior owner.

The issuance of new regulations and Rev. Proc. 2004-11 provide certainty and significant tax saving opportunities for taxpayers who can benefit from a cost segregation study. This guidance extends beyond newly acquired or constructed property, but also extends to property inherited by taxpayers from processor entities. Moreover, as a result of a landmark tax court decision involving Hospital Corporation of America (the progenitor of MACRS component depreciation), the IRS stated it would not challenge the allocation of basis from buildings to shorter-lived assets when a contemporaneous, independent third-party report substantiating the allocation exists.

Michael Greenwald is the tax partner in charge of BDO Seidman, LLP’s real estate practice. Randy Schwartzman is the tax partner in charge of BDO Seidman, LLP’s Melville office, chair of the NYSSCPA’s Mergers and Acquisitions Committee, and a member of the NYSSCPA’s Closely Held and S Corporations Committee.