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When to Expense vs. Capitalize Costs and Benefits of Cost Segregation

The accounting and tax rules around construction and real estate development can often be vexing. Two of the areas of interest that developers frequently encounter are (1) capitalization versus the expensing of costs and (2) segregation of certain assets in to different groups to maximize tax benefits. The former is an accounting compliance issue, and the latter presents a tax savings opportunity.

When to Expense vs. Capitalize Costs

One question real estate developers are faced with is when to capitalize and when to expense costs incurred before, during, and after production. The following is a quickguide to define key terms and help you come up with answers.

Production Period

The production period for real property begins the date that any physical production activity takes place with respect to the unit of real property.

The following is a partial list of examples that may indicate whether the physical production activity has occurred:

  • Clearing, grading, or excavating of raw land;
  • Demolishing a building or gutting a standing building;
  • Engaging in the construction of infrastructure, such as roads, sewers, sidewalks, cables, and wiring;
  • Undertaking structural, mechanical, or electrical activities with respect to a building or other structure; or
  • Engaging in landscaping activities.

In the case of real property constructed by the taxpayer for use in their trade or business, the production period would end when the property is placed in service. In the case property developed for sale, the production period ends when the property is ready to be held for sale.

Direct Production Costs

All direct production costs of the property must be capitalized.

Real Estate Taxes

Real estate developers must capitalize real estate taxes paid—even if no development has taken place—if it is reasonably likely when the taxes are incurred that the property will be subsequently developed.

Interest Expense

Interest incurred before the production period begins may be deducted as an investment interest expense. Once the production period begins, interest expenses should be capitalized using the avoided cost method. Under the avoided cost method, any interest that theoretically would have been avoided if production expenses had been used to repay or reduce outstanding debt must be capitalized. At the end of the production period, interest would again be deductible.

If there is a suspension in the production period for a 120 consecutive days (without regard to normal delays for weather, etc.), capitalization of interest is not required and interest incurred may be retroactively deducted.

Insurance Expense

Any insurance expense properly allocable to the production activity must be capitalized and included in the basis of the asset when production is complete. These costs should be capitalized during the pre-production period if it is reasonably likely at the time the costs are incurred that production will occur at some future date.

Benefits of Cost Segregation

Cost segregation studies are used to reallocate building costs (from Section 1250 property, using straight-line depreciation) to tangible personal property (Section 1245 property, using accelerated depreciation methods).

Items that may qualify for accelerated depreciation include certain site work; drainage systems; landscaping; parking lots; parking and loading dock equipment; carpeting; special purpose electrical as well as heating; ventilation and air conditioning systems; awnings and canopies; sidewalk lighting; and decorative millwork. Specialty items that may qualify include window coverings, furniture, signs, security systems, bollards and guardrails, certain cabinets and counters, specialty doors, specialty lighting, kitchen equipment, refrigeration systems, and drive-thru equipment. Numerous other building components may also qualify.

Cost segregation studies provide the analysis and identification of specific building components necessary to allocate costs into the proper categories for depreciation purposes. According to the Internal Revenue Service’s Cost Segregation Audit Techniques Guide (ATG), there is no standard for cost segregation studies. However, the ATG defines a quality cost segregation study as having the following three attributes:

  • Classifies assets into property classes (e.g., land, land improvements, building, equipment, furniture and fixtures);
  • Explains the rationale (including legal citations) for classifying assets as either Section 1245 or Section 1250 property; and
  • Substantiates the cost basis of each asset and reconciles total allocated costs with total actual costs.

While cost segregation studies work well for new construction, they can also provide significant tax and cash low benefits for existing structures. Taxpayers may benefit from “catch-up” depreciation deductions on existing properties by filing IRS Form 3115, Application for Change in Accounting Method, under the automatic consent provisions of IRS Revenue Procedure 2014-17. The catch-up depreciation is the difference between the cumulative amount of depreciation taken under the originally reported depreciable lives and the amount that could have been taken using the depreciable lives reported by the cost segregation study.

For timeshare developers, these scenarios and points could all represent a significant opportunity for tax savings for non-inventory property that is currently classified as real property.

Reprinted with permission from ARDA, copyright 2016. To view the original article in Developments Magazine, please click here.

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