Tax Savings for Doctors: Accelerated Depreciation on Your Real Estate
I am often asked about tax savings for doctors.
That’s why I was excited to learn recently about a process for doctors to recognize tax savings if they own or are planning on buying office buildings, ambulatory surgery centers and other types of facilities.
Listen to my podcast interview with David Jaffe from Cost Segregation Services (http://costsegregationservices.com) to learn about accelerated depreciation strategies for your office real estate.
Below is a transcript of the podcast.
What is “cost segregation” and what is the economic advantage for physicians?
Cost Segregation is simply a better approach to depreciating commercial property. Physicians with their own practices either rent the space that their practice uses, or else own the building itself. Cost Seg can be applied to either situation. Many physicians of course also own commercial properties as investment vehicles, such as self-storage facilities, commercial buildings and apartments and rental homes – Cost Seg can be utilized on those as well.
Default depreciation periods are 39 years on commercial property and 27.5 years on residential. The entire value of the building is evenly split over that period for equal-sized deductions. Cost Segregation is an IRS-approved process of identifying personal property assets that often get buried or lumped together within the Real Property asset category. By undergoing a cost segregation study, these personal property assets are reclassified to the shortest possible depreciable life to enable the real estate owner to maximize his or her tax depreciation situation, thus reducing the current income tax obligations. The tax savings generate cash flow that owners can use to reinvest in the practice, purchase additional property, apply to principle payments or spend on themselves.
With Cost Seg, you’re actually pulling deductions you’ll qualify for decades in the future into deductions you can take today. The IRS doesn’t charge a cent for letting you use these future write-offs. In fact, they actively recommend Cost Seg: “As a practical matter, Cost Segregation Studies should be applied by taxpayers”, and that it is “a lucrative tax strategy that should be used on almost every major purchase of commercial real estate”
Cost Seg came about by business suing the IRS about having to depreciate over decades even though some components – think carpeting, built-in furniture, plumbing, paint – required replacement far sooner. The IRS lost the battle, and this created Cost Segregation as a tool to save on taxes.
Without getting “in the weeds” too much, please explain briefly to our listeners about IRS “repair regulations” as a basis for this potential tax savings?
The IRS Repair Regulations are both a carrot and a stick. They address something closely-related to Cost Segregation, but actually something different, with the potential of savings beyond what the Cost Seg process offers.
In a nutshell: you are now required to have a study performed that breaks-down the value of the systems inside your building, so you know replacement costs for each — HVAC, for example. By knowing the replacement cost, tax pros can now use a ratio test to determine whether an expenditure should be capitalized (and then depreciated) or if it can be written-off as an immediate expense.
Previously, there wasn’t enough guidance for CPAs and EAs, so some would be overly conservative and capitalize nearly everything, while others would expense nearly everything and hope to survive an audit. Still others used arbitrary rules like “Any expense over $25K must be capitalized.” The expectations have now been systematized, making it easier on both taxpayers AND the on IRS.
Now. The Repair Regs is they are meant to be applied retroactively – expense determinations in the past have to be viewed through the current regulation. This is actually wonderful for taxpayers, as in many cases, it offers additional deduction opportunities. If you wouldn’t capitalize a particular $50K expense now, you shouldn’t have done it previously. If you did, you’re actually allowed to pull it forward and write it off in the CURRENT tax year. We find that many dollars spent on past repairs and renovations can be converted into immediate deductions for you today.
What level of savings can doctors expect to receive?
A rule-of-thumb is $35-$45K cash can be kept in your pocket for each $500K of building cost. Another way to express this is that you’re probably tripling your deductions over the first 5 years of ownership. Don’t worry if you’ve already owned the space for years, because the law has a catch-up provision letting you pull the larger deductions you could have had previously onto your current return.
For example, I did a study this year for a very basic medical building. It was purchased in 2010 for $524K. By doing the Cost Seg study, on her 2016 taxes, the owner got an additional $73K in deductions beyond what continuing the straight-line process would have yielded. And this building had a very basic level of finish – the nicer the treatments and finish, the more of the building value is “personal” property, not “real” property, so the larger your deduction.
As for the savings from applying the Repair Regulations, that varies on a case-by-case basis. At this point you’re required to have a Building Systems Valuation – where there will be extra savings or not, you must become compliant. My company automatically includes this report as part of a Cost Seg study. If we see items unnecessarily capitalized on the depreciation schedule of your building, we report that in our free pre-analysis and tell you the additional amount you’re likely to save.
Why don’t more physicians know about this tax advantage?
You’re not alone if you haven’t heard of these tax rules – we believe there’s probably still only a 10% market penetration. It certainly explains why my company continues to grow after 15 years in business. You can bet owners of hundreds of millions in property know about these rules, because that really is their business.
Biggest reason your CPA wouldn’t have mentioned Cost Seg are several continuing misconceptions. First is that studies are expensive and save very little. Not so – studies I’ve performed have ROIs of anywhere from 20:1 to over 40:1, so that’s not true. Some believe that the numbers don’t pencil-out if your building isn’t over $1M. My company is cost-effective down to $250K in building value, and even less for leaseholders. Some believe “No Receipts, No Study” – simply untrue. Part of our expertise is determining valuations with no paperwork at all. And the last common misconception is that you need to perform a study the year you buy or build. As my medical example showed, that simply isn’t true.
I’d ask people to understand their tax professional’s position – there are over 74,000 pages of tax code, and no human can be experts on everything. My company specializes in a mere 4,000 pages or so. This lets us be true experts for our thousands of clients and many hundreds of accounting firms.
What, if any, downside is there to taking advantage of this opportunity?
First, let me tell you things that are NOT downsides, ok? When you perform a Cost Segregation, you do not amend previous tax returns. You also do not add any additional likelihood of being audited. With those out of the way, let me tell you actual downsides. The first is that Cost Seg might not be appropriate if you know you’re selling the building in under 3 years, and you’re not planning to buy a replacement property (as you would when getting another or a larger space). That’s information you should tell your vendor when considering doing a Cost Seg procedure. However – if you plan on selling the building but using the proceeds towards purchasing another, you can roll everything forward, using what’s known as a 1031 Exchange. In that case, Cost Seg is entirely appropriate.
If the building is owned by a “reet”, a Real Estate Investment Trust, then the efficacy of Cost Seg depends on how the trust is setup. That’s another question for the potential vendor before proceeding with a study. Otherwise, it doesn’t matter if you own the building in your name, or are a shareholder of a corporate entity that owns the Real Estate – your tax professional will know how to file the results – or if you’re our client, we’ll help them.
Tell us a bit about CSSI and your process for how you work with your clients and, presumably, their CPA or other tax professional?
CSSI was founded in 2002, and is now the largest Cost Seg vendor that isn’t part of an accounting firm. We grew 25% last year and 20% the year before, and have completed nearly 16,000 studies to date. As an important side note, we’ve never had one of our studies – not even one of our calculations(!) denied by the IRS. Most of the largest accounting firms have in-house groups to do this work for their clients, but it can get quite expensive that way.
Before doing any work for you, we perform a pre-analysis by looking at the property’s tax depreciation schedule. We conservatively estimate your savings in a 10-page report that shows your depreciation deductions over time if you make no change and if you perform a study, so you can see the difference. We also give you a firm price for our work. If you’re not impressed with the savings, there’s no obligation to hire us.
This is when we look at the depreciation schedule to see if there are items that can be converted to expense by applying the repair regulations. If so, we estimate your additional deductions and if that changes our cost for the additional work on our part. We also take into account any other deductions that apply in your situation. For example, there’s something called “Bonus” depreciation still in force, a deduction called Section 179, and three different kinds of Qualified Improvement Property, or QIP. Our expertise lets us give you credit for all of these, and apply them the correct way.
I should mention that there are several Cost Seg methodologies that the IRS deems acceptable. We use the one called the engineering basis – for two reasons: The IRS calls it “the certain method”, which is their way of saying best and most reliable. The second reason is that this method also finds, i.e. segregates, the most personal property in a building, yielding the best results for the owner.
Once you review our pre-analysis and hire us, an analyst gets assigned to your project. They work with you and your tax pro as needed to get us the documents and facts we need to perform your study. In 6-8 weeks, your study is completed we give that to you and your tax professional, along with Repair Regs valuation for compliance there. If your tax person has questions on how to categorize something, report or implement, we will help them for you.
Also: if you’re ever audited and the IRS has questions about our work, we will defend if for free. As I mentioned, we have a perfect record after more than 15 years in business and nearly 16,000 studies.
If any of our listeners want more information from you, how should they contact you?
My name is David Jaffe. My cell# is 503-329-3993 and my email is David@CostSegSvcs.com.[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]