As published in Scotsman Guide's Commercial Edition, October 2007.
Borrowers can increase cash flow by taking advantage of cost-segregation studies. If you don't already, it's worth it to tell your clients about the benefits of cost segregation. This adds value to your relationships and can help loans pencil out.
In general, your borrowers can deduct the costs associated with acquiring, constructing or improving a building from their taxes for a specific number of years. The default period for most buildings is 39 years; for apartment buildings, it's 27.5 years.
A cost-segregation study identifies assets in and around a building that can be written off more rapidly -- over five-, seven- or 15-year periods. Assets that qualify for these shorter write-off periods include electrical outlets, piping, carpeting, lighting and landscaping.
Faster write-offs apply to federal and state income taxes, and they create immediate tax savings for borrowers. This allows for significant cash-flow increases. For example, investors who put $39,000 into a building without cost segregation would have a yearly deduction of about $1,000 for 39 years. If the depreciation period changed to five years, the yearly deduction would be almost $8,000 for five years -- an eightfold increase.
Because the rules governing which assets qualify for shorter recovery periods are complex, your clients typically need to work with a cost-segregation company. They should work with a company with knowledge of the construction process and experience in cost estimating, cost allocation and blueprint analysis.
The best time to recommend that borrowers look into a cost-segregation study is during the loan process. Getting the process started should be easy at this point because your clients have the necessary paperwork to determine benefit estimates and fee quotes.
With acquisitions, the cost-segregation professional will only need to see an appraisal to estimate the benefits and fees of the study. For new construction, the professional will request a brief description of the improvements and a copy of the loan-disbursement requests.
Most cost-segregation professionals provide benefit estimates for free, and they notify borrowers of the potential tax savings. An added benefit to mortgage brokers is that the estimated increase in cash flow can help in evaluating borrowers' creditworthiness.
In the case of acquisitions, you should also recommend that your clients have their land values appraised. This saves some of the guesswork involved in reporting land and building values separately for federal tax purposes.
Without a land valuation, borrowers tend to rely on property-tax bills or, worse yet, come up with their own estimate of the land value. Because the Internal Revenue Service requires that a building's value be determined by subtracting the land value from the total acquisition cost, self-estimates create an unnecessary IRS audit risk.
Cost segregation doesn't work for everyone. Nonprofit organizations and other tax-exempt entities cannot benefit from it. Additionally, cost-segregation studies will not immediately help taxpayers who currently have net operating losses because the accelerated deductions will be postponed until income is generated.
Further, investors who seek to flip properties within five years generally don't have much to gain from cost segregation. Because the process effectively delays a tax bill by accelerating tax deductions, a taxpayer would still need to pay taxes on any accumulated tax depreciation at the time of sale.
In today's market, increasing cash flow is a great way to strengthen borrowers' balance sheets. It also provides a higher comfort level for lenders.
Many borrowers are unaware of cost segregation and its benefits. You should be the one to advise them.
CJ Aberin is a senior manager at KBKG Inc., a cost-segregation specialist, and is based out of the company's headquarters in Pasadena, Calif.
For a free preliminary analysis, call KBKG at (877) 525-4462, ext. 503. For more information about the company, visit www.costsegregation.com.