property

Segregating the cost components of a “real” property allows for optimal cost recovery to increase after tax income

Posted on by abrahamwien18

PJ Pictureby Paul L. Jones, CPA, Director, Emerald Skyline Corporation

In the fourth quarter of 1985, Philip Morris Inc. agreed to buy General Foods for an estimated $5.6 billion. At the time, it was the largest food company acquisition in history. Pursuant to this acquisition, Philip Morris had to allocate the purchase price among cash and cash equivalents, real estate, tangible personal property, identifiable intangible assets and, finally, goodwill.

In conjunction with this cost allocation, Kenneth Leventhal & Company, a CPA firm that specialized in real estate, was hired to value the property, plant and equipment and segregate them into real, personal and land improvement assets to establish basis for its tax returns. I was a leader on the team that completed the study and valuation. The project involved hundreds of properties on six continents, the expertise of an untold number of real estate, engineering and accounting professionals – and over a year – to complete.

The reason we segregated the personal property and land improvement assets was to shorten, to the extent possible, the time required, and maximize the deductions from taxable income, to recover the cost of the assets through depreciation resulting in reduced income tax obligations. Accordingly, the primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for non-residential real property). Personal property assets, consisting of non-structural elements, exterior land improvements and indirect construction costs which are found in a cost segregation study generally include items that are affixed to the building but do not relate to the overall operation and maintenance of the building.

The investment strategy for every rental residential apartment complex and commercial building, including office buildings, shopping centers, industrial facilities, hotels, restaurants, entertainment complexes and all other commercial properties that are being acquired, constructed and/or sustainably renovated to be “Green” should include accelerated depreciation realized from a cost segregation study.

cost-segregationBy increasing the depreciation deduction, current income taxes are reduced and after-tax cash flow increased during the initial years of ownership or completion of substantial sustainable renovations – when their net present value and positive impact on the investor’s internal rate of return is the greatest.

A cost segregation study, in a nutshell, is the process of identifying any personal property and land improvement assets that are grouped with real property assets, and accounting for them separately, in particular, for Federal income tax purposes. The determination of what property components qualify for shorter depreciable lives as personal property is ultimately based on asset-specific facts and circumstances. However, consultants rely heavily on precedents existing in both case law and IRS guidance.

The law, rules and procedures relied upon in cost segregation studies have been around since the enactment of the Investment Tax Credit (ITC) in 1962 which established the legal rationale used to distinguish personal from real property for purposes of the ITC and provides the framework for the same classification process in cost segregation studies.

While the ITC was repealed through the Tax Reform Act of 1986, a landmark tax court decision in the case of Hospital Corporation of America (“HCA”) vs. Commissioner, 109 TC 21 issued in 1997 upheld the application of cost segregation for differentiating the depreciable basis of real, personal and land improvement assets. The HCA case is the seminal case for cost segregation studies and the IRS has agreed that a taxpayer can use a cost segregation study to segregate building costs. Critical to the Tax Court’s analysis was that in formulating accelerated depreciation methods, Congress intended to distinguish between components that constitute IRC section 1250 class property (real property) and property items that constitute section 1245 class property (tangible personal property). This distinction opened the doors to cost segregation.

Armed with this victory, taxpayers have increasingly begun to use cost segregation to their advantage. The IRS reluctantly agreed that cost segregation does not constitute component depreciation (action on decision (AOD) 1999-008). Moreover, cost segregation recently was featured in temporary regulations issued by the Treasury Department (regulations section 1.446-1T). In a chief counsel advisory (CCA), however, the IRS warned taxpayers that an “accurate cost segregation study may not be based on non-contemporaneous records, reconstructed data or taxpayers’ estimates or assumptions that have no supporting records” (CCA 199921045).

Real property eligible for cost segregation includes buildings that have been purchased, constructed, expanded or remodeled since 1987. A cost segregation study is typically cost-effective for buildings purchased or remodeled at a cost greater than $750,000. These studies are most efficient for new buildings recently constructed, but they can also uncover retroactive tax deductions for older buildings, which can generate significant short benefits due to “catch-up” depreciation.

Property owners should consider using a cost segregation study if they:

  • Acquired property in the last 15 years
  • Recently completed or started a construction project
  • Inherited property from an estate and received a stepped-up basis
  • Purchased a partnership share
  • Expect to pay income taxes
  • Plan on holding the property for at least five years

Examples of assets that may qualify to be reclassified as Section 1245 property (tangible personal property) which have shorter depreciable lives include:

  • Land improvements (drainage and irrigation systems, fencing, outdoor lighting, landscaping, parking lots and walkways, etc.);
  • Ornamental fixtures;
  • Wall and floor coverings;
  • Security systems;
  • Cabinets and millwork;
  • Data and communication cabling;
  • Decorative lighting;
  • Window treatments;
  • Production machinery;
  • Electrical and plumbing service to specific equipment;
  • Energy management systems;
  • Equipment, machinery and equipment that meet the “sole justification test” (i.e., building system components the sole justification for the installation of which is the fact that such equipment….are essential for the operation of other machinery or the processing of materials or used in connection with research of experimentation); and
  • Moveable wall partitions, catwalks and mezzanines

According to IRS Publication 544: “The fact that the structure is specially designed to withstand the stress and other demands of the property and cannot be used economically for other purposes indicates it is closely related to the use of the property it houses. Structures such as oil and gas storage tanks, grain storage bins, silos, fractionating towers, blast furnaces, basic oxygen furnaces, coke ovens, brick kilns, and coal tipples are not treated as buildings, but as section 1245 property.”

In distinguishing between a building’s tangible personal property and structural components, Jay Soled and Charles Falk in a 8/1/2004 article entitled “Cost Segregation Applied” in the Journal of Accountancy, “CPAs, engineers and consultants will find the courts to be a final source of guidance. In Whiteco Industries, Inc. v. Commissioner (65 TC 664 (1975)), for example, the Tax Court set forth the following six questions that can use to determine whether property is inherently permanent and thus a structural component excluded from the definition of tangible personal property:

  • Can the property be moved? Has it been moved? (For example, a shed with a concrete floor vs. a shed with a wooden floor.)
  • How difficult is removal of the property, and how time-consuming is it? (For example, a wine cellar vs. a prefabricated photo-processing lab.)
  • Is the property designed or constructed to remain permanently in place? (For example, a wooden barn vs. a wire chicken coop.)
  • Are there circumstances that tend to show the expected or intended length of affixation—or that the property may or will have to be moved? (For example, permanent concrete pilings vs. floating docks that can be removed in the winter.)
  • How much damage will the property sustain upon its removal? (For example, a steel-encased bank vault vs. an easily removable lighting system attached by bolts.)
  • How is the property affixed to the land? (For example, permanently glued bathroom tile vs. removable billboard.)

Even with ample regulatory, legislative and judicial guidance, making the distinction between tangible personal property and a building’s structural components remains a challenge for CPAs. No bright-line test exists. What is fortunate, however, is that many of the factual issues involving properties of different sorts have been litigated, and their outcomes illuminate the direction a court confronted with similar facts is likely to take.”

The primary property recovery periods are:

  • Buildings = 27.5 years for residential and 39 years for commercial
  • Land Improvements = 15 years
  • Furniture, fixtures & equipment = 7 years
  • FF&E, Retail & service = 5 years
  • Information systems = 5 years

Cost segregation consultants generally employ one of two methods, or a combination of both, that have approved by the IRS:

The first approach is to obtain and examine actual cost data records and construction documents in conjunction with a site visit to identify assets for potential reclassification. This approach is typically used when the property has been recently constructed and documents are readily available. The consultant assigns costs to each component based on any information provided, analysis of the documents and site visit.

The second approach, applicable when the original construction documentation is not available, is typically performed when a study is performed in conjunction with the purchase of the property. This alternative is also performed when the cost segregation study is conducted several years after initial construction. In applying this approach, an engineer or consultant will analyze architectural drawings, mechanical and electrical plans and other blueprints to segregate the structural and general building electrical and mechanical components from those linked to personal property. Using standard construction cost estimating tools, the property is “reverse-engineered” into its separate components. The consultant will also allocate “soft costs,” such as architect and engineering fees, to all components of the building. Total actual property costs are then allocated to the components on a proportional basis.

The information and documents typically required for a cost segregation study include:

  • legal description of the property
  • Date placed in service
  • Building and land area
  • Survey
  • Architectural and building plans
  • AIA documents 702 & 703
  • Other construction documents and accounting records
  • Depreciation schedules
  • Fixed asset listing
  • Construction loan documents, if available
  • Settlement statement
  • Appraisal

The consultant provides a self-contained cost segregation report, certified by the study’s authors, that will satisfy IRS requirements.

The benefits can be significant. BKD LLP, CPAs calculates that “Each $100,000 in assets reclassified from a 39-year recovery period to a five-year recovery period results in approximately $16,000 in net-present-value savings, assuming a 5% discount rate and a 35% marginal tax rate.

By reclassifying an asset from building (1250) to personal property (1245) property, the magnitude of an additional allowance in the first year can be enormous. For example, a shift of $1 million from 39-year property to 5-year property can augment first-year depreciation deductions by a whopping $575,000 ($25,000 vs. $600,000). Note: The application of the alternative minimum tax may reduce some of the tax savings associated with cost segregation.

Cost segregation studies should be performed by consulting firms with expertise in engineering, construction, tax and accounting. The IRS’ underlying assumption in determining what constitutes a quality study is that the study is performed by “personnel competent in the design, construction, auditing, and estimating procedures relating to building construction.”

Emerald Skyline Corporation, whose principals include real estate, sustainability, resiliency, architecture and accounting professionals is uniquely qualified to provide cost segregation advisory services to building owners, investors, managers and accountants in conjunction with your sustainability and resiliency project. Each cost-segregation study prepared by Emerald Skyline includes an identification of any available Green Building Tax incentives. Often overlooked, these valuable tax credits can amount up to 30% of qualified expenditures and increase the tax benefits of a cost segregation study.

New Phase I Environmental Assessment Standard Just the Starting Point for Managing the Purchase of Contaminated Property

Posted on by abrahamwien18

February 25, 2014
Peter R. Duchesneau
Partner, Manatt, Phelps & Phillips, LLP
View the original article here

On December 30, 2013, the U.S. Environmental Protection Agency (“EPA”) adopted ASTM E1527-13, an updated Phase I environmental assessment standard for performing all appropriate inquiries to establish landowner liability protections under the U.S. Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”). This new Phase I protocol clarifies the previous standard for all appropriate inquiries, which is an important first step, but not the only one for establishing landowner liability protections. With the adoption of ASTM E1527-13, buyers of potentially contaminated property should take the opportunity to revisit the other requirements and scope of landowner liability protections. By doing so, prospective purchasers will not only better their chances of effectively establishing such protections, but can also better manage risks that may fall beyond them.

CERCLA Landowner Liability Protections
Under CERCLA, existing property owners are strictly liable for the cleanup of contamination of their property, including new owners who acquire the property years after the contamination occurred. To promote the development of contaminated property, on January 11, 2002, President Bush signed the Small Business Liability Relief and Brownfields Revitalization Act, Public Law 107–118 (‘‘the Brownfields Amendments’’), which amended and clarified CERCLA by establishing three forms of landowner liability protections for new owners of contaminated property: the bona fide prospective purchaser (“BFPP”), the contiguous property owner, and the innocent landowner.

To qualify for these CERCLA landowner liability protections, the Brownfields Amendments provide that parties purchasing potentially contaminated property must comply with a number of requirements, including undertaking ‘‘all appropriate inquiries’’ into the ownership and use of the property prior to purchase. On November 1, 2005, the EPA promulgated regulations that set standards and practices for all appropriate inquiries and authorized the use of ASTM E1527-05 to comply with the rule.

ASTM E1527-13 Phase I Standard
In November 2013, ASTM International published ASTM E1527-13, “Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process,” replacing ASTM E1527-05. In many respects, ASTM E1527-13 is the same as its predecessor. However, the new standard contains some important revisions, including a clarification that all appropriate inquires must include an assessment of vapor migration and vapor releases on, at, in or to the subject property. Other revisions to the standard include updated definitions of “Recognized Environmental Conditions” (“REC”), “Historical Recognized Environmental Conditions,” and “de minimis conditions,” as well as the addition of a new form of REC, “Controlled Recognized Environmental Conditions.” ASTM E1527-13 also contains additional requirements pertaining to regulatory agency file and records review and clarification of the “User” obligations.

A New Property Owner’s Post-Acquisition Obligations
For the most part, the requirements to establish the three protections are similar, including the necessity of performing all appropriate inquiries prior to purchasing property. While many prospective purchasers diligently attempt to perform all appropriate inquiries, the other requirements can be overlooked, as can the limitations of CERCLA landowner liability protections.

Perhaps of most concern are real property transactions where contamination or other recognized environmental conditions are identified in the course of performing all appropriate inquiries. Despite such knowledge, as a BFPP, the new owner can largely be exempt from CERCLA liability for preexisting contamination. Yet the requirement to establish the BFPP defense does not end with performing all appropriate inquires under ASTM E1527-13 prior to purchase. Buyers also have important obligations after the acquisition of property.

Parties seeking the benefit of the BFPP protections must establish, by a preponderance of evidence, each of the “painstakingly detailed statutory elements,” as one court put it in the course of rejecting a bid to secure the BFPP protections. See U.S. v. Slay, 2013 U.S. Dist. LEXIS 46204, n. 6 (2013). In all, there are eight statutory elements, including that a new property owner must provide all legally required notices with respect to the discovery or release of hazardous substances at the property; exercise appropriate care with respect to the hazardous substances found at the facility by taking reasonable steps to stop any continuing release, prevent threatened future releases and preventing or limiting exposure to previous releases; and provide full cooperation, assistance and access for response actions.

A number of courts have recently declined or otherwise expressed doubt as to BFPP claims due to the claimants’ failures to demonstrate they met their post-acquisition obligations. For instance, in Saline River Properties, LLC v. Johnson Controls, Inc., 823 F. Supp. 2d 670, 686 (E.D. Mich. 2011), the court held that the defendant had failed to demonstrate that it had not impeded performance of a response action when it broke up a concrete slab alleged to have caused hazardous substances beneath the barrier to migrate into additional soils and groundwater. In Voggenthaler v. Maryland Square, 724 F.3d 1050, 1062-1063 (9th Cir. 2013), although the Court of Appeals remanded the issue to the trial court, it expressed skepticism that the party would be able to establish a BFPP defense and show it prevented further harm and limited exposure to preexisting contamination after it demolished a building and took no steps to remove the contaminated soil or limit its spread. Similarly, in PCS Nitrogen v. Ashley II of Charleston, 714 F.3d 161, 180-181 (4th Cir. 2013), the court found that a party’s delay in filling in sumps and not stopping runoff amounted to failure to exercise appropriate care, thwarting its BFPP defense.

Environmental Risks Outside CERCLA Landowner Liability Protections
Even where a party can establish CERCLA landowner liability protections, the scope of such protections warrants careful consideration for buyers of contaminated property. There are a number of environmental risks that fall outside the purview of the CERCLA landowner liability protections. For instance, the protections do not extend to releases of fuel from underground storage tanks, given CERCLA’s petroleum exclusion. Nor do the protections necessarily apply to state cleanup claims or toxic tort actions, with laws varying by state. For example, under the California Land Reuse and Revitalization Act of 2004, an agreement with a state environmental agency must be entered into before the land owner liability protections will attach. Buyers must also be astute of contractual provisions for property acquisitions that may stymy the protections.

Despite the potential limitations of the CERCLA landowner liability protections, ASTM E1527-13 establishes a valuable starting point for buyers to assess potential environmental risks of real property and achieve CERCLA landowner liability protections. However, prospective purchasers need to remember that all appropriate inquiries is only the start and just one element for managing environmental risk when acquiring contaminated property. Other means to manage risk may be necessary, and new property owners should take care not to neglect post-acquisition obligations to achieve landowner liability protections.

Peter R. Duchesneau is a partner in the Los Angeles office of Manatt, Phelps & Phillips, LLP. His practice focuses on environmental law involving litigation, administrative proceedings, regulatory compliance and business transactions. He holds a B.S. degree in Chemical Engineering; is admitted to practice before the U.S. Patent and Trademark Office; and regularly advises clients on corporate and real estate transactions, Brownfields, and environmental due diligence. Mr. Duchesneau can be reached at (310) 312-4209 or [email protected].

This column is part of a series of articles by law firm Manatt, Phelps & Phillips, LLP’s Energy, Environment & Natural Resources practice.