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Cost Segregation Studies: Best PracticesReclassifying Business Personal Property to Achieve Income and Property Tax Benefits

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THURSDAY, APRIL 5, 2012

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Daniel McGrath, Director, Grant Thornton, Chicago, , , g

Gian Pazzia, Principal, KBKG Inc., Pasadena, Calif.

Julio Gonzalez, Founder and CEO, Engineered Tax Services, West Palm Beach, Fla.

Dennis Duffy, President, Duffy + Duffy Cost Segregation Services Inc., Westlake, Ohio

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C t S ti St di B t P ti Cost Segregation Studies: Best Practices Seminar

April 5, 2012

Daniel McGrath, Grant [email protected]

Dennis Duffy, Duffy + Duffy Cost SegregationServices [email protected]

Julio Gonzalez, Engineered Tax Services

[email protected] Pazzia, KBKG Inc. [email protected]

Today’s Program

Reasons To Perform A Cost Segregation Study Slide 7 – Slide 12Reasons To Perform A Cost Segregation Study[Dennis Duffy]

When To Start The Process With A New Facility[Daniel McGrath]

Slide 7 Slide 12

Slide 13 – Slide 16[Daniel McGrath]

Performing A Retroactive Study[Daniel McGrath]

Slide 17 – Slide 21

Applicable Rules, Standards And Guidance[Gian Pazzia]


Designing A Study With Defending It In Mind[Julio Gonzalez and Dennis Duffy]

Experiences With Audits


Slide 47 – Slide 50Experiences With Audits[Dennis Duffy, Daniel McGrath, Gian Pazzia, Julio Gonzalez]


REASONS TO PERFORM A Dennis Duffy, Duffy + Duffy Cost Segregation Services Inc.

REASONS TO PERFORM A COST SEGREGATION STUDY

Standard Features Of The CostSegregation ProcessSegregation Process

• Gather basic information about the property and the owner’s tax situation

• Prepare a projection of the accelerated depreciation and an estimate of the net present value of the deferralsestimate of the net present value of the deferrals

• Evaluate estimate cost and other tax ramifications, and discuss with owner

• If a study is desirable, gather construction drawings, specifications and cost data

• Perform site visit to verify drawings, take photos and gather y g , p gfurther information

• Prepare and deliver report

8

Reasons To Perform A CostSegregation Study

Cost segregation studies can provide property owners with accelerated depreciation deductions that defer income tax.

Many property owners are unaware of the benefits of cost segregation. Many owners do not know that studies can be applied retroactively to properties acquired in the pastapplied retroactively to properties acquired in the past.

The accelerated depreciation deductions generated do not p grequire an additional cash outlay.

9

Identifying Construction‐Related Costs Thaty gCan Be Depreciated Over A Shorter Life

• Separates non-structual elements, exterior land improvements and indirect conctruction costsconctruction costs

― Tangible personal property (Sect. 1245 property)

― Not “structural components” of a building

Does the item relate to the operation or maintenance of the ― Does the item relate to the operation or maintenance of the building?

― Land improvements

― Can be Sect 1245 or Sect 1250 propertyCan be Sect. 1245 or Sect. 1250 property

― Does not include costs inextricable to the land

― Indirect construction costs

“Soft costs” such as permits architect fees builders overhead and ― “Soft costs” such as permits, architect fees, builders overhead and profit

― Indirect costs can be allocated to the asset to which they relate.

10

Adjusting Timing Of Depreciation ToMaximize Cash Flow For Other Purposes

For new construction: Significantly higher deductions in the early years, amplified by bonus depreciation and a higher Sect. 179 limit

For existing properties: Immediate recapture of retroactive deductions on property acquired since 1987

― “Catch-up” Sect. 481A adjustments, taken in year of change witout amending!

― In certain circumstances, this may produce a net In certain circumstances, this may produce a net operating loss that can be carried back to produce refunds of tax paid in previous years.

11

R d i P TReducing Property Tax

Studies can be used for property tax appeals.

A study conducted before property acqusition may be used to specify personal property tax.

― Personal property enumerated in purchase agreement

― May reduce transfer tax on real estate

12

WHEN TO START THE Daniel McGrath, Grant Thornton

WHEN TO START THE PROCESS WITH A NEW FACILITY

C Y S d PCurrent‐Year Study Process

• When to begin

― New construction/expansion/remodel

P t ti― Pre-construction

― Formal process

Informal process― Informal process

― During construction

― Formal processFormal process

― Informal process

― Post-construction

― Acquired facility

14

C Y S d P (C )Current‐Year Study Process (Cont.)• Whom to involve

― Internal personnel

― VP of tax/Director of tax/Tax manager

― Head of construction or real estate/Project engineer/Facility manager

― Fixed asset managerg

― IT representative

― External expertise

― Cost segregation provider

― Tax compliance provider

Contractor personnel― Contractor personnel

― Project architect/Engineer15

C Y S d P (C )Current‐Year Study Process (Cont.)• Co-sourcing opportunitiesg pp

― Scope of work

― New construction

― Acquisition

― Pros

Potentially reduced professional fees― Potentially reduced professional fees

― Increased tax department involement in fixed asset decisions and operations

― Work for under-utilized personnel

― Cons

Personnel time demands― Personnel time demands

― Fee reductions less significant than anticipated16

PERFORMING A RETROACTIVE Daniel McGrath, Grant Thornton

STUDY

R i S diRetroactive Studies

• Ability to apply cost segregation to prior-year assets

• Typically yields more significant benefits than a current-year study

― Porfolio of properties

― Small projects for which current year cost seg didn’t make sense

― Prototype facilities utilizing statistical sampling

Assets placed in service since 1/1/87― Assets placed in service since 1/1/87

― Current-year Sect. 481(a) ”catch-up” adjustment

― Bonus depreciation and qualified leasehold improvement property

• Form 3115 automatic change in accounting method

• Can complete study up until extended due date of return

• Additional opportunities related to expensing repairspp p g p

18

R i S di (C )Retroactive Studies (Cont.)• Types of assets to include

― Constructed/expanded/remodeled buildings

― Acquired buildings (asset or stock deals)

B ild f l d ― Build-out of leased space

― Project indirect costs

― One-off asset additionsOne off asset additions

― Replace carpeting

― Add computer room A/C

― Network cabling

― Parking lot expansion

New production line― New production line

• Whom to involve19

R i S di (C )Retroactive Studies (Cont.)• Process

― Review tax depreciation schedule

― Data request

Facility site visits and interviews― Facility site visits and interviews

― Cost analysis

― Estimate costs from blueprints and construction cost data manuals

― Recalculate depreciation and calculate Sect. 481(a) adjustment

― Prepare Form 3115

Create deliverable including workpaper documentation― Create deliverable, including workpaper documentation

― Upload results into fixed asset system

― Update capital asset manual and/or process for the future

20

R i S di (C )Retroactive Studies (Cont.)• Co-sourcing (more opportunities and efficiencies than current-year studies)

― Potential company personnel scope of work

― Populate templates and analyze costs

― Gather quantities of assets to reclassify

― Calculate depreciation and 481(a) adjustment

― Assemble supporting documentation

― ProsPros

― Potentially reduced professional fees

― Increased tax department involvement in fixed-asset decisions and operationsoperations

― Work for under-utilized personnel

― Cons

Personnel time demands― Personnel time demands

― Fee reductions less significant than anticipated

21

APPLICABLE RULES, Gian Pazzia, KBKG Inc.

,STANDARDS AND GUIDANCE

Updates: Economic StimulusUpdates: Economic Stimulus

T R li f U l t I R th i ti d J bT R li f U l t I R th i ti d J bTax Relief, Unemployment Insurance Reauthorization, and Job Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (P.L. 111Creation Act (P.L. 111--312)312)

100% bonus depreciation Property placed in service between 9/9/10 and 12/31/11

Extension of 50% bonus through 2012 (2013 for certain property)

NATIONWIDE SERVICE KBKG.com23

U d t E i Sti l (C t )Updates: Economic Stimulus (Cont.)

Qualified property is:Qualified leasehold improvements (QLIs)MACRS property with GDS recovery period of 20 years or lessWater utility propertyComputer software (with the exception of software covered by Sect. 197 (purchased as part of a business)Long production period property

Qualified property is not:Qualified restaurant and retail improvementsAlternative depreciation system (ADS)


R P 2011 26Rev. Proc. 2011-26Component election

Special election available in 2010 AND 2011 to “componentize” construction costs Anything incurred after Sept. 8, 2010 gets 100% bonus Even if more >10% project complete and paid for before 9/8/2010 Without this election you are limited to 50% Without this election, you are limited to 50%.


R P 2011 26 (C t )Rev. Proc. 2011-26 (Cont.)Component election (Cont.)

Example: Client starts construction on $10M building in June 2010. Complete $2M by Sept 8 2010 ($500k is bonus eligible)Complete $2M by Sept 8, 2010 ($500k is bonus eligible) $8M completed after 9/8/2010 ($2M is bonus eligible) Everything is placed in service in 2011.

Without election: ALL short life property gets 50% bonus = $1.25M. With election: Any short life property segregated from $8M gets

100% bonus = $2.25M.

Difference of $1M of deductions in Year 1


$

R P 2011 26 (C t )Rev. Proc. 2011-26 (Cont.)

Qualified restaurant and retail property, and bonus eligibility

• Bonus regs say qualified retail/restaurant property is not bonus-g y q p p yeligible.

• Bonus eligible : If property is both qualified restaurant/retail propertyBonus eligible : If property is both qualified restaurant/retail property AND qualified leasehold improvement


R P 2011 26 QLI A d LPPPRev. Proc. 2011-26, QLI And LPPPLong production period property

Clarification that long production period property started in 2011 can still get 100% bonus deprecation on the entire basis, as long as it’s g p , gplaced in service in 2012

LPPP defined: Tax life over 10 years costs exceeding $1M andLPPP defined: Tax life over 10 years, costs exceeding $1M, and production period over 1 year


Rev. Proc. 2011-26, QLI And LPPP (Cont.)

Long production period property (Cont.)

Example: Client is spending $3M on tenant improvements. Meets criteria for qualified leasehold improvement property (15- Meets criteria for qualified leasehold improvement property (15

year life) Started in February 2011 and will be done in April 2012 (> 1 year) ALSO meets criteria for LPPP ALSO meets criteria for LPPP

Entire amount gets 100% bonus treatment, because it took longer th 1 !than 1 year!

If completed in January 2012, it would all get 50% bonus. Difference of $1.5M of deductions in Year 1!


15-Year Improvement D i ti Q i k R fDepreciation Quick Reference


R t D l t /C LRecent Developments/Case Law

PPL Corporation v Commissioner (July 28 2010)PPL Corporation v. Commissioner (July 28, 2010) Electric utility’s street lighting - depreciable over 7 years IRS Guidance (CCA201123001) – 2011 Truck service stations: Asset class 57.1, with 15-year tax lifeRev. Proc. 2011-42: Rules for Statistical Sampling Estimates IRS criteria to determining whether to accept a statistical sampling g p p gTemp regs for 263(a): Repair vs. capitalization, Dec. 23, 2011 Peco Foods vs. Commissioner (January 2012)Amerisouth TC Memo (March 2012)Amerisouth TC Memo (March 2012)Rev. Procs. 2012-19 and 2012-20


Temp Regs For 263(a): Repair V. C it li tiCapitalization

Guidance when certain building expenditures should be expensedGuidance when certain building expenditures should be expensedSignificant changes to the 2008 proposed regs Clarification of “unit of property” definitionsDefine nine “building systems” and require each to be treated asDefine nine “building systems” and require each to be treated as its own UOP, for repair vs. capitalization analysisMajor structural component includes any combination of parts that perform a discrete and critical functionperform a discrete and critical function Define improvement as betterment, restoration or adaptionPlan of rehabilitation doctrine is now obsolete!

Removal of structural component is a disposition; can now write off the remaining basis of 1250 building items removed


Temp Regs For 263(a): Repair V. C it li ti (C t )Capitalization (Cont.)

E l Cli t t t d 3 t ffi b ildi i 2002 f $5MExample: Client constructed 3-storey office building in 2002 for $5M.

In 2008, business spent spend $1M to remodel portion of 2nd floor (ceilings, walls, lighting, plumbing, ducting, electrical wiring, etc.).(ceilings, walls, lighting, plumbing, ducting, electrical wiring, etc.).

Did cost seg on $1M remodel

But also realized greater benefits from retirement of items But, also realized greater benefits from retirement of items demolished/abandoned

Abandonment study on original building: Engineer identified and quantified an additional $400K of deductions in Year 1.


Temp Regs For 263(a): Repair V. C it li ti (C t )Capitalization (Cont.)

Pl f h bilit ti d t i i b l tPlan of rehabilitation doctrine is now obsolete.

Client spends $3M on a remodel.

Costs include work on portion of roof, asphalt patching/resurfacing, 2 HVAC unit replacements, painting.

Old rules – All capitalized Old rules – All capitalized

New rules require a UOP analysis to determine if those can be expensed in the current year.

Make sure you are using a cost segregation firm that fully understands all the new rules under “repair regulations.”


RP 2012 19 A d RP 2012 20RP 2012-19 And RP 2012-20Both Modify Rev. Proc. 2011-14 (Change of Accounting Methods)

IRS Procedure 2012-19 Deducting repair and maintenance costs Capitalizing acquisition or production costsp g q p Capitalizing improvements to tangible property

IRS Procedure 2012-20 Dispositions of MACRS property spos t o s o C S p ope ty Depreciation of leasehold improvements (can’t amortize over life of lease) Changes in tax life for property depreciated under MACRS

Simplified process by allowing two or more concurrent changes of accountingSimplified process by allowing two or more concurrent changes of accounting to be filed on single Form 3115.

Allow the use of statistical sampling for certain changes, as long as the sampling plan follows guidelines in Rev. Proc. 2011-42


Peco Foods, Inc., TC Memo 2012-18 J 201218, January 2012

Acquired two poultry processing plant businessesAcquired two poultry processing plant businesses

Purchase agreement included a schedule allocating purchase price among assets, which included building improvements and machinery

d i tand equipment.

This is a Sect. 1060 transaction (sale of a trade or business), so the company filed the required Form 8594.co pa y ed t e equ ed o 859

Peco did a cost segregation study following the purchase and was denied under audit.

Tax Court ruled in favor of the IRS.


Peco Foods, Inc., TC Memo 2012-18 (C t )18 (Cont.)

Is this applicable to all real estate transactions?Is this applicable to all real estate transactions? The courts examined how the purchase agreement defined building

improvements and personal property. Those definitions did not consider the IRC definitionsthe IRC definitions.

Be very careful about how the purchase agreement is worded! Consult with a cost segregation expert that understands this case.

Do not use the term “building” to describe the facility. Be specific and provide a schedule of the FF&E and M&E. Make sure to

define personal property and reference back to that listdefine personal property and reference back to that list. Consider doing a cost segregation before the purchase, so that the

buyer and seller agree to allocations.


AmeriSouth XXXII, Tax Court M 2012 67 (M h 2012)Memo 2012-67 (March 2012)

Acquired an apartment complex in 2003 for $10.25 millionAcquired an apartment complex in 2003 for $10.25 million

Hired a cost segregation firm to do the study

AmeriSouth sold property at about the time the case was tried and AmeriSouth sold property at about the time the case was tried, and stopped responding to communications from the court.

The case could have been dismissed entirely. But, since AmeriSouth didn’t file a post-trial brief, the court deemed any factual matters not otherwise contested to be conceded.

Tax Court denied almost all the items reclassified in the cost Tax Court denied almost all the items reclassified in the cost segregation study.


AmeriSouth XXXII, Tax Court M 2012 67 (C t )Memo 2012-67 (Cont.)

This has been brewing for a few years.This has been brewing for a few years.

KBKG believes some positions taken in the cost segregation study were aggressive, but most were not.

Site utilities are generally not 15-year property.

Kitchen sinks, plumbing and cabinetry, and finish carpentry

Stove hoods, electrical panels

KBKG knows of two more cases going to Tax Court on these issues g gand believes the results will be different.


179D F C i l B ildi179D For Commercial BuildingsImmediate deduction of up to $1.80/square foot for “commercial buildings” that are 50% more energy efficient than under certainbuildings that are 50% more energy efficient than under certain 2001 building standardsNot related to Sect. 179 expensing

Partially qualifying property Whole $1.80/square foot Up to $0.60/square foot for building envelope Up to $0.60/square foot for HVAC Up to $0.60/square foot for interior lightingUp to $0.60/square foot for interior lighting


American Society Of Cost S ti P f i lSegregation Professionals

ASCSP Required testing and experience requirements to be certified

(CCSP) Requires reports adhere to ASCSP standards and Code of Ethics Ongoing training, education and certification procedures for cost

segregation consultants

IRS engineers – guest speaker at several ASCSP Conferences ASCSP issues comments to IRS on repair regulations. ASCSP position on AmeriSouth case ASCSP position on AmeriSouth case. ASCSP commentary on Peco Foods case


Julio Gonzalez, Engineered Tax Services

DESIGNING A STUDY WITH

Julio Gonzalez, Engineered Tax ServicesDennis Duffy, Duffy + Duffy Cost Segregation Services Inc.

DEFENDING IT IN MIND

Best Practices For A Defensible Audit Trail

Principal Elements Of A Defensible Cost Segregation StudyPrincipal Elements Of A Defensible Cost Segregation Study

The 13 principal elements of a defensible study are:1) Preparation by an individual with expertise And experience

2) Detailed description of the methodology

3) Use of appropriate documentation

4) Interviews conducted with appropriate parties

5) Use of a common nomenclature

6) Use of a standard numbering system6) Use of a standard numbering system

7) Explanation of the legal analysis

8) Determination of unit costs and engineering “take-offs”

9) Organization of assets into lists or groups

10) Reconciliation of total allocated costs to total actual costs

11) Explanation of the treatment of indirect costs

12) Identification and listing Of Sect. 1245 property

13) Consideration of related aspects (e g IRC §263A change in accounting method and 13) Consideration of related aspects (e.g., IRC §263A, change in accounting method and sampling techniques)

43

Best Practices For A Defensible Audit Trail (Cont.)

A cost segregation report reflects a study’s methodology and conclusions. The amount of detail included in a report can id bl d di th i id H th b t f d t l i t tl f d vary considerably, depending upon the service provider. However, the subsequent fundamentals are consistently found

in a defensible report.

1) Summary letter/Executive summaryA defensible report contains a summary to identify: The preparer; the date of the study; the taxpayer (or client); the subject property; and the property components classified as land, land improvements, building or personal property.

2) Narrative reportA defensible report discusses the theory, definitions and rationale behind the study in the narrative section.This section generally includes a more detailed description of the property/facility (i.e., a physical description and

l i f h f hi h i i i d d ll l l d i i f h d i l i ) I an explanation of the use for which it is intended, as well as a legal description of the property and its location). In addition, the narrative section highlights the regulations, rulings and court cases that support classifying assets as §1245 property. The narrative also discusses the types and sources of data used (e.g., cost records, contracts, purchase agreements, published estimates) as well as how they were used.

3) Schedule of assetsA lit t h h d l f t th t th f f th t d G ll thi h d l ti di tl t A quality report has a schedule of assets that are the focus of the study. Generally, this schedule ties directly to the taxpayer’s depreciation records. When a taxpayer reallocates costs of assets already “on the books,” a quality report clearly identifies the specific assets affected (and includes depreciation records from both before and after the reallocation).

4) Schedule of direct and indirect costsA lit t li t ll di t d i di t t i t d ith j t I di t t ll t d t §1245 A quality report lists all direct and indirect costs associated with a project. Indirect costs allocated to §1245 property are clearly identified and explained. Separately-acquired assets are listed and discussed in the report. to avoid duplication errors. Costs subject to IRC §263A also are addressed.

44

Best Practices For A Defensible Audit Trail (Cont.)

5) Schedule of property units and costs) p p yA defensible report provides a schedule of property units and costs (with property descriptions) that are segregated into land, §1245 property and §1250 property. This schedule is the final product of the study and serves as the basis for computing depreciation.

6) Engineering proceduresA defensible report describes the engineering procedures and methodology for determining the cost of A defensible report describes the engineering procedures and methodology for determining the cost of each property unit. It also identifies the specific taxpayer records that were reviewed, and discusses whether actual cost records or estimating techniques were utilized to break costs into smaller components. A record of inspections and/or interviews is included as well. The use of a common nomenclature or a standard numbering system also is referenced and/or explained.

7) Statement of assumptions and limiting conditionsA defensible report describes the general understanding and conditions applicable to the report. This information may also provide an indication of the overall quality of the study.

8) CertificationA defensible report certifies that the person who signed the report actually developed the analysis, A defensible report certifies that the person who signed the report actually developed the analysis, opinions and conclusions of the report. This section may also include the resume or state the credentials and/or level of experience of the preparer.

9) ExhibitsA defensible report generally includes various exhibits, such as the “Client cost sources” and the “Cost S R ili ti ” Th hibit h th “b k” (GAAP fi i l ti ) d hi h th Source Reconciliation.” These exhibits show the “book” (GAAP financial accounting) records on which the preparer relied in deriving total costs, and may include a reconciliation of the study to the fixed asset ledger. Photographs and/or videos may also be included as exhibits, to assist in understanding the assets in the study.

45

Creating An Audit Trail, FromConstruction Drawings Through Reports

Drawings are maintained as part of the study documentation.

U f t k ff h t t d t d t Use of take-off sheets to record measurements and counts

Adequate photographs and descriptions Adequate photographs and descriptions

Reference to case law and/or IRS guidance for items Reference to case law and/or IRS guidance for items segregated

46

Dennis Duffy, Duffy + Duffy Cost Segregation Services Inc.Daniel McGrath, Grant ThorntonGian Pazzia, KBKG Inc.

EXPERIENCES WITH AUDITS

Gian Pazzia, KBKG Inc.Julio Gonzalez, Engineered Tax Services

IRS A di E iIRS Audit Experiences

IRS wants a clear audit trail and rarely challanges take-offs or costs.

Agents rely on the IRS Audit Techniques Guide for authorative support.

― Guide clearly states that it is not intended as an official IRS pronouncement and may not be cited as authority.y

― Case law is factually intensive, and rulings often conflict.

48

IRS A di E i (C )IRS Audit Experiences (Cont.)

• Historical (pre-2010)

― Frequency

― Experience of IRS personnelExperience of IRS personnel

― Examples

― Typical situations

― Restaurant franchisee

― Medical office building

C d i• Current and prospective

― Frequency

― Primary focus has been repairs-expensingPrimary focus has been repairs expensing

― Depreciation

49

C St d Li hti R t fitCase Study: Lighting Retrofit

200,000-sq-ft. industrial building200,000 sq ft. industrial buildingIn 2011, spent $300,000 to replace all the lighting KBKG’s analysis $250 000 Lighting Meets 50% testKBKG s analysis All the lighting meets the testDeduction = $120,000

( $ )200,000 SF

$250,000 Lighting Meets 50% test

Deduction = (200,000 x $0.60) Client expenses $120,000 in the current year.

Expense$120,000 in current year

Shopping Center

$120,000 (200,000 x $0.60)

Instead of depreciating the whole $300k over 39 years


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