For federal income tax purposes, most buildings are assigned a 39-year life; accountants by and large use that same 39-year time period for book depreciation as well as taxes. If nothing else, this use of the same life for books and taxes effectively eliminates any deferred tax accounting. Further, using a 39-year life seemingly accords with economics; many buildings may face a degree of functional depreciation or economic obsolescence within that time period.

While there are many buildings in use today that were constructed before 1972, this fact alone does not call into question the use of a 39-year life. The reason is that there is an active market in all types of buildings and there is a high probability that within the first 39 years the original owner will sell to a third party. Under any type of accounting the new owner of an existing building would start depreciating it based on the cost to the new owner and the expected life to that new owner. Perhaps for simplicity, or from habit, second owners usually also assign their own 39-year life.

Put in plain English, it requires that companies who comply with International Financial Reporting Standards (IFRS):

In practice this means that, for example, a company would determine the cost of roofing separately from the cost of the heating, venting, and air conditioning (HVAC) system; it would then assign a specific life to the roof and to the HVAC system and depreciate them separately. Similarly, the cost of special lighting or floor covering, and other items considered personal property, would have to be determined and given its own life.

The IFRS requirements are clear that you are not supposed to depreciate a building as a single line item, based on an overall composite weighted life. Each component with an identifying material cost must be treated as a separate line item; depreciation is calculated for that specific category based on its own estimated economic life.

Thus, instead of a single line item entry for a “building,” as is now commonly done in the United States, the company sets up perhaps ten or more line items, the total of which of course sum up to the overall building cost. Under IFRS land is originally entered at its cost, as is done in the United States.

At one point there was a proposal by the Accounting Standards Executive Committee (AcSec) of the American Institute of Certified Public Accountants (AICPA) that U.S. accounting for buildings should be based on individual components, similar to the IFRS model. The AICPA and the Financial Accounting Standards Board (FASB) explored this idea in some detail and subsequently dropped it, based in large part on unfavorable input from many companies. There was fear expressed by the FASB’s corporate constituents that a lot of extra work would be entailed in the accounting departments.

Further, the respondents correctly assessed that depreciation expense would be accelerated; as a consequence initial depreciation expense for financial reporting purposes would be accelerated and reported income would be lower. That depreciation is considered a “noncash charge” and is routinely added back to earnings before interest, taxes, depreciation, and amortization (EBITDA) in the quarterly reports to shareholders was either not considered or was disregarded.

For whatever reasons, the FASB dropped the proposal and little has been heard of it since, at least for financial reporting in the United States.

As a side note, as this is written (2011) there is a lot of discussion about possible U.S. adoption of IFRS, or at a minimum permitting U.S. companies to use IFRS instead of GAAP (generally accepted accounting principles). This difference in accounting for PP&E (property, plant, and equipment) is not one of the differences usually discussed but in practice might represent almost as large a change as the IFRS prohibition against last in, first out (LIFO).

Sometimes referred to as “cost segregation,” this strategy of component depreciation for tax purposes has saved taxpayers, in total, literally billions of dollars. There are really two mysteries here. Why do more companies not use component depreciation or cost segregation for taxes and if they do why do they not use the same system for financial reporting?

If any readers have not investigated cost segregation for any buildings they own, the savings from undertaking such a study are guaranteed to provide a huge return on investment (ROI) on the purchase of this book.

So, just what is a “cost seg” study, as it is familiarly called? In its simplest form, a trained professional, one with an engineering and construction background, as well as an understanding of valuation and tax law, decomposes a building into its construction elements. Then a separate life is assigned to each category of asset based on its tax classification under current Internal Revenue Service (IRS) rules. Again, as discussed in Chapter 4 there is no requirement that companies adopting component depreciation for financial reporting would have to use the same lives elsewhere, but if they do adopt the same lives there would be no need for deferred tax accounting.

Cost segregation or component depreciation is not a magic bullet. At the end of 39 years the exact same amount of depreciation will have been taken for taxes and for books as under the simple, “one-size-fits-all” 39-year life. But by taking the depreciation earlier through componentization the time value of money provides a big win for the taxpayer. Exhibit 14.1 shows that, at an assumed 10% cost of capital (the rate that many real estate professionals use) the present value of the tax savings can amount to almost 6% of the building cost.

Understanding the contents of Exhibit 14.1 will allow the reader to see how the concepts apply to any building they own. The example assumes a cost of $5 million for the building; the cost of the land would be kept separate and not be part of the analysis.

The valuation specialist will work with the blueprints of the building and separately identify the cost of each item of 5-, 7-, 15-, and 39-year property. We do not show the detailed supporting schedules prepared that identify each type of asset within that life category but they are part of the final cost seg study report prepared for each building.

The detailed knowledge of exactly what constitutes say five-year property, and the ability to determine the current cost of each item, is the professional knowledge that is required. We explicitly recommend that a cost seg study be performed by specialists in the field; this is not a fertile field for a “do-it-yourself” undertaking. The reason is simple. The IRS will challenge a study that contains mistakes made by people not intimately familiar with the court cases and regulations; the IRS does accept, often without question, a study prepared by a professional whose work they have looked at in the past and approved.

Getting back to Exhibit 14.1, it shows that the analyst has identified some $750,000 of 5-year property, $100,000 of 7-year property, and another $750,000 of 15-year property. The balance of the total cost, kept as 39-year property in this example, is $3,400,000.

Going to row 1, Exhibit 14.1 shows the depreciation expense allowed for each category for year 1, out of the total 39-year expected life for the total. Because of the half-year convention the first year has lower depreciation than years 2 through 39 with another half year in year 40.

Consequently, under this cost seg study the company could in year 1 deduct $245,374 of depreciation, rather than the $64,100 allowed under the normal life schedule of the IRS. This $181,274 of extra depreciation in year 1 is followed in years 2 through 15 with the amounts shown in the “Change in Depreciation Expense” column.

Then in year 16 the depreciation “turns around” and less is allowed for taxes than is permitted for books. This turn around reflects the impact of the shorter lives and accelerated depreciation allowance that has now run its course. This example, of course, is constructed on the assumption that the company does not adopt component depreciation for financial reporting.

Looking at the bottom line of Exhibit 14.1, one sees that on an undiscounted basis there is the same total $5 million of depreciation. Obviously, you are not permitted to charge more total depreciation expense than you paid for the building in the first place.

But because of the time value of money, in this example 10%, the larger expenses allowed in the early year do offset on a present value basis the smaller allowances in subsequent years. In this case there is a net benefit to the taxpayer of $289,526 for the total project life of 39 years. At its peak in the first six years there is an even greater cash-flow benefit but this is partially offset by the turnaround in years 16 through 40. Of course 10% discount rate amounts in years 16 through 39 are worth much less than amounts in year 1 through 16, hence the net savings.

Every time a building is bought by a new owner, that new owner is permitted to perform his own cost seg study on his actual purchase price. This means that if the reader’s company has bought a used building it is still permitted to apply a cost seg approach to its purchase price not including land.

The potential cash flow benefits differ for different types of buildings, as a percent of the total cost. Once again, we must caution readers that you cannot take a percent from this schedule and simply claim greater depreciation expense for the early years. Every building has different cost and engineering characteristics and “rules of thumb” no matter how accurate, will not be accepted by the IRS.

A specific report for your building by a cost seg analyst can be prepared that will estimate accurately the anticipated savings based on your actual facts and circumstances. In almost every case there are potential savings that are quite likely to be derived. It behooves every CFO and controller at least to explore the potential savings with every building their company owns.

Our firm’s experience is that almost without exception, the first year’s tax savings more than pays the total cost of the cost seg study, which might approximate $10,000 to $15,000. Why more building owners do not avail themselves of this tax-saving strategy is one of life’s mysteries.

It is our understanding, although you should check with your own tax professional that a cost seg study can be performed in years subsequent to the original purchase. A form is filed with the IRS requesting a “change in accounting.” Approval of this request is virtually certain because of prior decisions by tax court. With that approval, it is then possible to file amended corporate returns and obtain a current cash refund for the excess taxes paid, based on the new analysis showing shorter tax lives.

There have been a number of tax court cases dealing with component depreciation. Some were won by the IRS and others by the taxpayers. But each court decision, on a specific asset classification, has been incorporated into the work of cost seg professionals.

The IRS now has at least four engineering agents who specialize in reviewing cost seg studies. The IRS has developed a detailed audit guide for cost segregation that is to be used by regular revenue agents, not just engineering agents. In the Appendix to this chapter we show a small excerpt of the IRS audit guide. The full text is accessible in the www.IRS.gov web site if you put “cost segregation” in the search box.

It is not necessary for a reader to go through the entire audit guide. It is worthwhile to note that the IRS is starting to take cost seg seriously and is challenging taxpayers’ claims if they are not based on sound and approved methodology. We cannot recommend a specific professional organization but as with any professional service there can be variations in fee and professionalism. As a ballpark estimate, however, a cost seg study for a moderate-sized building would cost in the range of $10,000. This amount would be offset through tax savings in well less than a year, with subsequent annual savings falling directly to the bottom line.

This audit guide would help a tax professional who is considering having a cost seg study performed by one of the firms that specialize in this service. Reviewing it would give one an idea of the activities that must be performed and how the IRS reviews it. Inasmuch as cost seg studies in this country are solely for tax purposes it really is up to the company’s tax advisors, and the cost seg specialist, to make sure that the work conforms to IRS requirements.

We reiterate again our advice. Other than to have the cost seg work performed in the first place, this is not a suitable topic for a Do-It-Yourself approach. While it sounds simple on the surface to break out the costs of the relative components, in practice there are a lot of grey areas that the specialist understands and has had experience in how to handle.

The final tax savings may well be the same, but the effort to obtain the information, and hence the cost, will be reduced in terms of the cost seg study.

In some localities there is a property transfer tax. There are potential savings on such property transfer taxes if one separates out personal property from real property, but this is possible only if the analysis is completed prior to the closing so the appropriate amounts can be filed on a timely basis. The same analysis, which will help reduce transfer taxes will also be used in the cost seg study, so this really gives great incentive for buyers of real estate to build this directly into the internal procedures and reviews for real estate acquisitions.

There are two types of companies in the United States that can effectively use componentization in financial reporting: utilities and defense contractors. Utilities are regulated and their rates are a function of their cost base, so the more they can assign to such assets, the greater will be their allowed return. Besides utilities, defense contractors usually have extraordinarily good property records. This of course is because such contractors are closely audited by the defense contract audit agency and some revenues are in turn based on allowable costs, including depreciation for assets used for the specific contract. If you have a cost-based contract it behooves you to have as many directly assignable costs as you can, and component depreciation is a good way of allocating costs to contracts.

There is one more factor that should be considered, and that is subsequent maintenance. If you have a single large dollar asset on the books, then subsequent smaller expenditures are likely to be considered maintenance and charged to expense. To the contrary, if you have relatively small individual items on the property record, and replace one of them, you will write off the undepreciated cost of the old asset and capitalize the cost of the new replacement.

This tension between expense and capitalization is inherent if a company goes to componentization. In effect a greater amount of subsequent expenditures will be capitalized if each individual component is separately identified. If the entire building is a single line item, then it is almost mandatory to charge almost all subsequent expenditures to expense and you would be precluded from capitalizing them. We are not recommending one way or the other, but readers should be aware of the consequences of either approach.

First, reported depreciation expense will be higher, although this does not affect cash flow or EBITDA. More rapid depreciation is considered by some analysts to be a “plus.” Value line, for example, in their weekly company analyses calculates an overall depreciation rate, with the implication that the faster a company depreciates its assets the better off it is.

The second impact of using cost seg tax lives and depreciation for financial reporting is the elimination of deferred tax assets and liabilities for this category.

Finally, while it is too early to predict whether, or when, IFRS will be used in the United States, Controllers should be fully aware that IFRS not only permits, but requires, componentization. We believe this is the wave of the future, and because of the immediate tax savings, companies would be well advised to start now.