[Note: To follow is an excerpt of an interview with Kimberly Manning, Emerging Resource Group, a key advisor to entrepreneurs, corporations and investors on creating wealth-utilizing real estate, and Jim Shreve an engineering economist and CEO of Cost Segregation Services. To listen to the show archive or download an MP3, go to www.IncomePropertyInvestmentTalk.com/070109.]
Mosca: Cost segregation, from the definitions that I can find, is the study that identifies and reclassifies personal property assets to shorten the depreciation in time for tax purposes, which reduces current income tax obligations. Can you tell us about cost segregation, how it started and why it’s important to a real estate owner and investor?
Shreve: Cost segregation was created in and out of a court case in 1997. The court case was Hospital Corporation of America vs. the IRS. What that court case did from a tax attorney’s description of its result was clarify how depreciation could be applied to any commercial property for profit in America. That court case simply did this, it said that the traditional description of a property and a building had two categories to analyze, not just the entire property as what was called real property in the definition of the tax law. Since 1997, many more court cases have helped to define those elements of a property that are again personal versus real, but they are still attached to the building. Those rules have created this discussion that’s called cost segregation today. We’ve done over 5000 studies nationally. In the application of cost segregation, it is important that you bring in professionals that understand what the IRS expects in its definition for application. It is a 500-page document on the guidelines of the application of cost segregation by the IRS and their review of those applications. This is important to the IRS and to the application of cost segregation for those people who own commercial property. To date in America it’s my estimate that there are not more than 10 to 15% of all properties in America having applied this. From a cost segregation point of view, as a company that’s providing this in every state in the country, we’re finding that we’ve done 5000 properties and we only have 4,000,000,000 left to go.
Mosca: In talking about cost segregation, I would think that one of the key members of that team would be a CPA. Are there CPAs that are specialists?
Manning: Yes, that is correct but what I am finding is most people assume that their CPA is well informed on every aspect of taxes and issues relating to that part of their business and that is not always the case. They need a CPA that specializes in tax accounting.
Shreve: Part of what happened in the industry when the court case was first completed was only the very largest companies in America could afford to figure out how to do this and part of my involvement in the industry early on was to develop the engineering methods to apply the tax rules that change because of the court case. We went on to develop the systems and processes to apply the engineering studies to properties that had already been applying depreciation for many years but wanted to take the advantage of the cash flow impact cost segregation. Many small companies were not given the opportunity like many of the large companies in America to apply this to their properties. We created a model that allows for property owners that own property as low in value as $350,000-$500,000 to get the mathematical benefit of cost segregation in their business. Generally speaking, the cost range on a property of say a half-million dollars would be somewhere between $3000 and $4500. The savings on that half-million dollar building would be between $40,000 and $55,000. A million-dollar building would be somewhere between $75,000 and $110,000. The good news is that our cost of getting this done for the client is also tax-deductible so if you look at the after-tax cost in comparison to the after-tax savings, you’re usually getting a 20 to one business result on this type of application. The up side to this is significant to the people who own commercial property. It is like low hanging fruit of creating cash flow out of the application of the tax rules for commercial property owners in America.
Mosca: Kimberly, are you finding that your clients are welcoming this opportunity capital into their lives?
Manning: My clients are initially very excited about the opportunity capital. What usually puts a question mark around it is the CPAs’ interest in the process. Once you get past the CPA, clients are receptive to the opportunity capital. I had one person who had a $30,000 potential return but since the CPA did not bring it to them or the CPA couldn't explain why they weren’t on the forefront of bringing it to the client, they minimized the whole process.
Mosca: Jim, is what Kimberly mentions a reason why you are stressing the importance of the consultative view to this particular process, sitting down with owners and CPAs and someone like yourself, who understands the IRS rules and regulations back and forth?
Shreve: Exactly. It’s interesting that out of the application the tax rules require two different professionals that normally do not come together to get the job done -- an engineer and a CPA. CPAs need engineers to interpret this for them. It’s been very slow to bring engineers into the marketplace to assist CPAs to get this done properly. The good news is that we have created and modeled what I call a very efficient methodology that in four to six weeks turns the application into a completed result for a property owner. From the time they hear about it, from the time they have one of our associates in their area or their city talk to them about this, we will do a full demonstration of the economics that they can recognize. Every building in America has a varying degree of upside created out of cost segregation.
Mosca: What are some other ways that these cost segregation studies are helping owners or prospective owners?
Manning: I’ve been meeting with a banker at a rather large bank here in Maryland. He informed me that cost segregation is an exceptional way to maneuver through the approval process. Basically the potential buyer can go in and negotiate the savings with the seller and leverage that as a way to get a better interest rate and if it’s a viable deal most banks will favor that more because it shows all the risk upfront. On the back end, a lot of banks are already utilizing cost segregation but depending on the relationship you have with your banker, they may or may not disclose how it's going to benefit you but some are using it as a reason to justify decline on the loan.
Shreve: We created a bank model that is Web-based that we give to bankers to use at their desk and it shows the effect of cost segregation on the debt service coverage ratios at the time they loan money to a commercial property investor. The idea being that if in a million-dollar building we create another $80,000 in cash in the first five years of ownership, we are taking and improving the debt service coverage ratios in the riskiest time of ownership -- the first five years.
Mosca: What is your golden nugget for today?
Manning: Consider and execute cost segregation as a way to increase your opportunity cash. Get more money in the bottom line. Cost segregation is something every company should be looking at.
Shreve: If you have commercial property today you can basically look at six to 8% of that value coming to you as after-tax savings. If you have a million-dollar property, you can expect $60,000-$80,000 in creating what I call opportunity capital in the choice to use the cost segregation application. We have our experts all over the country to provide this service for you and remember we are going to do a no cost analysis to make sure this works for you before you have to make a decision. That’s important that you understand clearly the economic potential of this for your particular application.