Monday, May 14, 2012

How Cost Segregation Can Greatly Reduce Your Taxes and Increase Cash Flow to Your Business

As a business owner, you already know the importance of maintaining the positive and ideally increasing cash flow to your business. Proper management of your accounts receivable, and staying on top of outstanding debts owed to you is an important component.
In addition to this, you should always look for new opportunities to increase cash flow to your business. Besides obvious things, like growing your customer base, expanding product or service offerings, or investing more in your advertising and marketing budget, many businesses can greatly increase their cash flow by conducting a cost segregation study.
What is Cost Segregation?
Cost segregation is an IRS-approved application by which commercial property owners can accelerate depreciation and thereby reduce the amount of taxes owed.
Consider this: as a commercial property owner, it's very possible to increase cash flow from tax savings of 7-10% of your building costs within your first five years of ownership. That's $70-$100K for each one million in building costs!
Each $100,000 in assets reclassified from a 39-year depreciation schedule to a 5-year schedule results in approximately $16,000 in net-present-value savings (assuming a 5% discount rate and a 35% marginal tax rate).
Plus, if real property is reclassified as 5-, 7- and 15-year personal property, it might qualify for a 30% and 50% bonus depreciation! This bonus depreciation applies to new property in the first year it was placed in service. This can result in huge savings!
For instance, a shift of $1 million from a 39-year schedule to a 5-year schedule can augment first year depreciation deductions by $575,000 ($25,000 vs $600,000) The resulting cash flow can provide much-needed capital for numerous other projects.
This savings represents cash flow that business owners can use to reinvest in their business, purchase more property, or spend elsewhere.
This is simple, fully legal, and recommended in the Journal of Accountancy for CPA's. In a 2004 article, they stated, "A taxpayer can substantially increase cash flow by segregating property costs."
How Does Cost Segregation Work?
Your CPA will play a central role in the cost segregation process, and they may even recommend that you have a cost segregation study. They will be the ones to review and implement the findings in the required engineering report.
In order to meet IRS approval, this study has to be conducted on your property by a qualified engineering firm. This engineering report will segregate assets into four categories:
-Personal property
-Land improvements
-Buildings (which should be broken down further into component parts)
This segregating allows the property owner to achieve faster depreciation deductions, as well as possible easier subsequent write-offs, so that cash flow will be increased. Assets in the first two categories above enjoy relatively short useful lives, thereby, accelerated depreciation methods. Also, if the components of a building have been separately valued and a component later becomes worthless, the business owner can write it off more easily.
Personal property- Taxpayers can normally accelerate the depreciation of this property using a five- or seven-year schedule, rather than the conventional 27.5- and 39-year schedules. There is usually a huge tax savings premium for valuing this property as high as possible. Items in this category typically include items such as furniture, carpeting, computer equipment and decorative building elements.
Greater savings is possible with an engineering report that clearly identifies property as tangible personal property, as opposed to structural building components.
Land improvements- Like personal property, land improvements have a short useful life. Using this accelerated depreciation method, business owners can include such items as sidewalks, docks, fences, site utilities, landscaping and paving.
The building- Building owners should attempt to maximize a building's value; any residual value will be applied to non-depreciable land. Although separate components (such as a roof) are considered part of the building itself, there is value to depreciating each component separately. If one of the building's components later becomes worthless, the owner can write it off immediately.
Land- Whatever amount of the purchase price isn't accounted for in the above categories will be allocated to land. Valued in this fashion, land may have a relatively low or insignificant value. However, proper documentation normally will protect the taxpayer from an IRS challenge.
This engineered cost segregation study will result in a much higher depreciation expense and greatly reduced taxable income for the business/property owner.
Also, the IRS ruling states that cost segregation can be applied to all categories of buildings purchased or built since 1986, including renovations.
This means that cost segregation is not only applicable to the acquisition of new or existing property. It can be applied to previously acquired or improved structure, as long as the owner has the proper engineering report to justify cost segregation.
Plus, there is no need to amend your tax returns.
A cost segregation study typically takes four to six weeks to complete. After which your CPA will go over the results with you, and apply them to your tax return. In addition to realizing your tax savings, if there's been overpayment in past years, you can see immediate cash flow with refunds.
Advantages and Disadvantages
The advantages for accelerated depreciation greatly outweigh the disadvantages. Benefits include enhanced depreciation deductions, plus by front-loading these deductions, the time value of money is greater than had these deductions been spread over longer periods of time using slower depreciation methods.
Cost segregation can also result in lower local realty-transfer taxes. When a cost segregation study reduces the value of a building, this produces a reduction in the amount of transfer tax due.
Some disadvantages include the cost of the engineering study, and the understatement penalties for those that use it too aggressively.
David P. Montana has written, spoken publicly and worked as a corporate business advisor in the area of collection agencies solutions for thirty years.