February 28, 2017
Many businesses are reaping the tax benefits of a cost segregation study, and grocery stores are prime candidates for the IRS-approved process. Eide Bailly has provided cost segregation studies to a variety of grocery store owners, which has allowed us to identify a few questions that grocers commonly ask. They include:
Let’s take a look at some of the answers to these questions.
What Is a Cost Segregation Study?
A cost segregation study is an IRS-approved process (assuming the study is done following acceptable standards) that allows you to segregate the building components of your grocery store into shorter depreciable recovery periods. The result is a significant acceleration of your depreciation deductions resulting in a lower income tax bill and an increase in current cash flow.
How Is It Done?
A quality study should result in all of the building components being broken down and assigned to an appropriate depreciable recovery period. For a grocery store, those recovery periods generally are:
The process completed in performing a cost segregation study includes:
A quality study will use specialty engineering software that can download the building plans, perform all of the engineering calculations, and determine the appropriate pricing for the calculations by linking with a third-party pricing service. This methodology results in greater accuracy and more importantly, a document that supports engineering and pricing processes in one location.
A simple excel spreadsheet with “rule of thumb” percentages used to classify the building components won’t make for a quality study, and unfortunately, there are firms that will take shortcuts and playing an “audit lottery” game unbeknownst to their clients.
Who Are the Best Candidates?
After considering the cost of the study, clients generally will receive benefits in the following situations:
One misconception is that you have to own the grocery store to be a candidate for a cost segregation study. Cost segregation studies also apply to tenant and leasehold improvements. This is seen quite frequently in situations where the grocery store was purchased or constructed and is held in a real estate entity separate from grocery store operations.
An initial analysis to determine what the benefit of a study may be should come at no cost to you. A fair amount of time should be taken to complete this analysis and obtain an understanding of what the results may be, if there are any issues that may impact the result, and most importantly, if enough value would be generated to justify performing a study.
The most important factor in determining if a cost segregation study makes sense is probably the easiest question to answer. If you are paying significant taxes and are in a higher bracket, the benefit of a cost segregation study is easier to determine. If you are in a low bracket and have most of your income sheltered through other depreciation or other deductions, then the benefit of a cost segregation study is not nearly as significant. This is probably the most important question in determining if it even makes sense to complete the initial analysis.
What Are the Benefits and How Much Does It Cost?
Typically, you can expect to move 25-35 percent of the costs of a grocery store to the shorter 5-year and 15-year recovery periods. The summary below shows actual results of grocery store studies that have been completed by Eide Bailly in the last two years:
|Construction cost (1):||$8,085,000|
|Additional first-year depreciation:||$1,767,000|
|Tax benefit in the first year:||$ 687,000|
|Present value of the cumulative tax savings:||$ 705,000|
|Study cost:||$ 13,700|
|Percentage of costs moved to 5-year and 15-year||39.8%|
|Purchase cost (2):||$1,637,000|
|Additional first-year depreciation:||$ 210,000|
|Tax benefit in the first year:||$ 84,000|
|Present value of the cumulative tax savings:||$ 61,500|
|Study cost:||$ 8,700|
|Percentage of costs moved to 5-year and 15-year||24.3%|
|Construction cost (2):||$4,125,000|
|Additional first-year depreciation:||$ 925,000|
|Tax benefit in the first year:||$ 371,000|
|Present value of the cumulative tax savings:||$ 223,750|
|Study cost:||$ 10,200|
|Percentage of costs moved to 5-year and 15-year||35.1%|
(1) This project was a current year project and a change of accounting method was not required.
(2) These projects were placed in service in prior years, and the additional first-year depreciation reflects the “catch-up” of prior year depreciation that should have been claimed.
As you can see, the costs of completing the study ranged from $8,700 to $13,700 with a current year tax benefit that significantly exceeded the study cost. Generally, it will take 50-100 hours to complete a quality study. A discount rate of 5 percent was used in the above examples to determine the value of the cash flow that resulted from the acceleration of the depreciation deductions.
If your grocery business is showing growth in profitability and recovering from the economic challenges of the past few years, the following are examples of how a cost segregation study can be used in your continuing tax planning:
The dollar amount of the income tax savings (and resulting cash flow) will depend on the complexity of the property and the dollar amount of the investment. It is not unusual that the reduction in income tax liability can result in additional cash ranging from 5-10 percent of the original cost of the real estate investment.
Working With the New Repair Regulations
For calendar year taxpayers, the new repair regulations issued September 13, 2013, became effective January 1, 2014. The tax treatment for expenditures related to repairs, improvements and capital acquisitions are now most likely different than prior years.
Historically, a decision to deduct an item as a repair was often based on the dollar amount of the expenditure or the amount of the invoice. Typically, the higher the dollar amount, the greater the likelihood the amount was capitalized and depreciated. In many cases, this resulted in that item being depreciated over 39 years.
The new repair regulations are complicated, but generally are more favorable to grocery store owners than the prior rules. Starting January 1, 2014 (unless you elect to early adopt the new rules for 2013) some potentially currently deductible repair items include:
Unfortunately, there are no “bright-line” tests that can apply with certainty, so each of the above examples would require some review to determine deductibility. As a word of caution, any work that is done shortly after purchase will probably result in capitalization due to the notion that you may be repairing “wear & tear” of the prior owner and not for the period of time the property was owned and utilized by you.
The new repair regulations come with some opportunities should apply to most grocery store owners:
Many of the same concepts used in a cost segregation study also apply to the application of the new repair regulations. A construction specialist who understands how a building is comprised and how to apply the “unit of property” concepts to the building components can make supportable decisions on whether a repair can be deducted currently or whether it is a capitalizable expenditure. Remember, if it has to be capitalized, you are now entitled to take a partial disposition deduction for the component removed (if it makes sense to calculate the deduction).
When completing a cost segregation study on your grocery store or working with a group that understands the new repair regulations, it is important to understand the differences in quality that providers bring to the table. You can utilize the American Society of Cost Segregation Professionals (ASCSP) as a resource and we encourage you to complete your due diligence before selecting a cost segregation provider or selecting a provider to complete a Repair and/or Retirement Study. If you receive a quote and the number seems too good to be true, it probably is.