In an effort to stimulate new construction and renovation, the IRS provides incentives allowing hotel owners to write-off "personal property" over a shorter period of time against taxable income. This is in contrast with "real property" assets that are subject to either 15-year or 39-year depreciation schedules.
This process, known as "cost segregation," is the expertise and passion of Rick Swarts, President & CEO, Paragon Valuation Group. Paragon is a valued business partner of Cicero's,
one that we recommend with full confidence in their ability to save our customers money.
We recently sat down to talk with Rick to discuss cost segregation and why it is important that hotel owners take full advantage of it to maximize their profits and ROI. On our client's behalf and at no charge, Cicero's provides Paragon's staff with the information it needs for their comprehensive engineering and valuation analysis.
Q: Can you explain how cost segregation works?
To get a better handle on cost segregation, you need to know what assets IRS Regulations define to be "personal property." These would include:
any asset that is not performing a building function but is inside or attached to the building;
any asset that is dedicated to a business process, for example, a stove, a computer or furniture;
any asset that is easily removable without affecting the building functions.
Personal property assets can be written-off on a highly-accelerated five-year schedule instead of the 15-year land improvements or 39-year straight line schedule assigned to the physical building structure, and therefore can generate cash-flow much faster.
Q: Can you give us an example of how it works?
Consider an investor who purchases an existing hotel for $10,000,000. To write off the purchase price, the hotel's assets need to be allocated into different classes for tax depreciation. This includes the land, land improvements, building, furnishings, restaurant and bar equipment, fitness center, pool, and things like Internet connections, TV satellite dishes, and staff uniforms. If the accounting team classifies all these assets as being "real property," the total purchase price (less land) is written off at a rate of 1/39th per year for the next 39 years or about $256,000 annually. However, if 40% can be re-classified as "personal property," these assets are written off over five years: 20% the first year, 32% the second, 19.2% the third, 11.52% for the fourth and fifth, and 5.76% the sixth. The accelerated deductions generate this tax savings cash flow amounts to a total of $1,546,246 in tax savings over six years.
Q: Why don't more hotel owners use cost segregation?
Surprisingly, there is little awareness of this completely legal tax practice. Most hotel owners believe that their accounting firm is well versed in cost segregation and therefore, are already taking advantage of it. Or they believe that only a very small percentage of real estate assets can be reclassified as being personal property, so why bother since it will be written off eventually?
Unfortunately, unless the hotel's accounting firm has highly experienced electrical, mechanical, or architectural engineers on staff, they are likely not qualified to conduct detailed engineering analyses to identify which components qualify and then use valuation methodology to segregate the related costs for classified assets. Also, from our experience, we've yet to have a client who was not stunned by how many assets actually are personal property for tax purposes. We also like to remind hotel owners that while they are correct in saying all assets will be eventually depreciated, wouldn't they rather have the cash today than 39 years from now?
Q: How does it work with renovation projects?
For the new construction phase, there is no difference in the segregation process and tax benefits.
The BIG difference is Cash In The Trash that no one writes off against taxable income. All the disposed building components like roofs, chillers, water heaters, drywall, studs, electrical conduit & wiring, light fixtures, etc. have remaining tax basis eligible for write off. Determination of that basis requires a complex process of retrospective engineering analysis and valuation. In Illinois, every $1M of write off creates $491,000 of tax savings or real cash flow. Other states are similar depending on their tax rate.
Q: So is there any way to recover overpaid taxes from past projects?
The good news is YES! A little known IRS procedure allows retrospective cost segregation and allocation analyses to determine allowable but unclaimed depreciation, and disposals not written off. This deduction can be applied to the current year, carried back 2 years for a refund, or carried forward 20 years against taxable income until used up. Even better news is that amended tax returns are NOT required, just filing a simple form.
To speak with Rick, call 847-240-2981. To learn more about cost segregation, visit www.fixedassetexperts.com