The value of cost segregation for nursing homes and long-term care facilities
According to federal tax laws, cost segregation consists of identifying personal property assets that are grouped with real property assets, then separating personal assets for tax reporting purposes. In order to do this, you must hire an experienced engineer who should have a well-rounded understanding of construction finance. He or she can produce a cost segregation analysis that identifies and classifies personal property assets so that depreciation time is dramatically truncated-thus reducing one's tax obligations.
What is personal property? It consists of a building's non-structural elements, exterior land improvements and indirect construction costs.
The engineer you retain will examine all blueprints, (as well as architectural drawings, electrical plans) and isolate structural and mechanical components from those that are considered personal property. The cost segregation report also will identify architectural and engineering fees that can be segregated.
The report will identify "soft costs," such as architectural and engineering fees, that are components of the building. In addition, a well-documented and thorough cost segregation analysis will do the following:
1. Maximize tax savings by adjusting the timing of deductions.
2. Create an audit trail to help resolve IRS inquiries.
3. Take advantage of retroactive benefits. Nursing home operators can capture immediate retroactive savings on property added since 1987. The rules have been amended so that you can now take the full amount of an adjustment in the year the cost segregation is completed.
4. Provide significant opportunities to reduce real estate tax liabilities.
5. And, under certain circumstances, permit nursing home operators to qualify for a special 30% bonus depreciation allowed by the Job Creation and Worker Assistance Act of 2002 or a 50% bonus depreciation allowed under the Jobs and Growth Tax Relief Reconciliation Act of 2003.
The cost segregation study will identify building costs that would normally be depreciated over a 27.5- to 39-year period, then reclassify those costs, resulting in an accelerated method of depreciation. Such non-structural costs for items such as carpeting, wall coverings, some aspects of an electrical system, decorative lighting, indoor and outdoor plants, sidewalks and landscaping, can all be depreciated during the much shorter periods of five, seven or 15 years.
The larger tax deductions will result in increased cash ﬂow and a lower cost of capital, especially during the ﬁrst few years following an expansion project, renovation or purchase. A cost segregation study can significantly help identify opportunities for such periods of accelerated depreciation.
In order for nursing homes and long-term care facilities to take full advantage of cost segregation opportunities, buildings must have been purchased, constructed, renovated or expanded after 1987. While cost segregation is cost-effective for such new buildings, a well-done study can uncover tax deductions for buildings that pre-date 1987. In addition, buildings that are best suited for cost segregation should have a cost basis that is greater than $500,000.
In addition to providing tax relief, cost segregation can benefit the owners and operators of nursing homes and long-term care facilities in the following ways:
1. Maximizing tax savings by adjusting the timing of deductions. When an asset's life is shortened, depreciation expense is accelerated and tax payments are decreased during the early stages of a property's life. This, in turn, releases cash for investment opportunities or current operating needs.
2. Creating an audit trail. Improper documentation of cost and asset classifications can lead to an unfavorable audit adjustment. A properly documented cost segregation helps resolve IRS inquiries at the earliest stages.
3. Playing catch-up: Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties to increase cash flow in the current year.
4. Additional tax benefits. Cost segregation can also reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax savings opportunities.
Under certain circumstances, segregated assets may qualify for a special 30% bonus depreciation allowed by the "Job Creation and Worker Assistance Act of 2002" or a 50% bonus depreciation allowed under the "Jobs and Growth Tax Relief Reconciliation Act of 2003."
An example of cost segregation:
Suppose an individual purchases a healthcare facility for $10 million while the land is owned by another entity. If the purchaser does not use cost segregation, then straight-line depreciation over 39 years must be used.
If, however, an engineer is retained and produces a report that shows that of the total purchase price, $9 million should be for the building, $800,000 for a parking lot and $50,000 for landscaping and shrubbery, the facility owner could save more than $100,000 (assuming a tax rate of 35% and 5% discount rate).
Here is another example of the tax savings that can result from cost segregation: Suppose a cost segregation analysis shows that a building's siding had an initial value of $200,000. Five years later, it has a value of $150,000 and must be replaced. The facility owner could deduct $150,000 as a loss. Without a cost segregation study, the owner would be not able to take the deduction because the siding's tax basis and the cost basis of the building would not have been itemized as separate entities.
Altogether, a cost segregation study is an essential fiduciary component when you do any of the following:
* Build a new facility.
* Acquire an existing building.
* Renovate an existing facility or
* Expand a facility.
Owners and operators of healthcare facilities who do not hire the appropriate experts to conduct a cost segregation analysis will fail to take advantage of significant tax benefits.
Israel Segal is president of VFR Healthcare Finance (www.vfrfinancial.com), which specializes in all aspects of nursing home and long-term care facility financing.