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The Fabulous Facts On Cost Segregation
by Don McDougall, O'Connor & Associates

The truth is, most self-storage owners review their budgets and look for any way possible to cut expenses while still providing quality service to their customers. Nevertheless, many owners don’t  realize that one line item that can be cut is their federal income taxes. Many business owners assume that federal income taxes are a fixed expense and that the only way to reduce them is to make less  money. In reality, taxes can be reduced using the assets already in place through a process called “cost segregation.”

A History Of Cost Segregation
Before most of us were born, there was a thing called the “Investment Tax Credit (ITC).” It said that when you acquired personal property for business purposes, you could get a tax credit of 10 percent of  the equipment’s value. This was designed to help manufacturing companies compete in the global market. Soon, however, companies began identifying short-lived building components that also  qualified for the 10 percent tax credit, so the market for these services exploded. Companies were  listing everything from the glue that held down the carpet to the wall shafts of elevators as personal  property that qualified for a 10 percent tax credit.

As part of a balancing act to pass a series of tax cuts, Congress eliminated the Investment Tax Credit altogether, which seemed to spell the end for the  practice of breaking out building parts for tax purposes.

Consulting firms soon realized that, even without the tax credit, owners could still benefit by  accelerating the deprecation of the personal property assets. As a result, Component Depreciation studies were born out of the ashes of ITC. With few real rules, things began to get interesting. The  same folks who took the wall elevators were declaring a whole lot of assets as personal property¯  and, as such, short-lived assets.

Once again, the federal government stepped in and set up guidelines for what could and what could  not be considered personal property, controlling what could and what could not be given shorter lives.  The resulting set of rules is what brings us to where we are today: cost segregation.

So what is cost segregation? When you build a structure, you can segregate the costs of the building based on the useful life of the individual building components. You break the building in to five-, seven- , 15-, and 39-year components. As an example, the paving and exterior lighting can have a shorter life than does the frame of the building. For self-storage facilities, the interior doors are shorter lived than  the building frame.

The IRS has approved this segregation, and most of the procedures are clearly set out on its Web site and its Audit Technique Guide (ATG ). You can get a copy online at http://www.irs.gov/businesses/article/0,,id=134122,00.html. How does this benefit self-storage owners? Since the IRS allows for cost segregation, short-lived assets depreciate faster, meaning you keep  more of your tax dollars in hand now.

What Benefits Can You Expect?
Even better news is that the IRS allows you to play catch-up, so if you did not complete a cost segregation study the year you purchased the site, you can still take advantage of it. There are many variables. Below is a short list of the items that should be considered to estimate your savings:

• Building (square footage)
• Tonnage of AC (for climate control units)
• Land square footage
• Estimated percent of land that is paved
• Landscaping square footage (optional)
• Number of stories (optional)
• Number of storage access doors
• Year acquired

Why are all these topics relevant? Because the size of the building is only one of the variables. The  acreage of the property as a whole and how much of it has been improved are also key issues. The table below shows the benefits for some sample properties based on their size and age.

You will notice that the “catch-up” allows you to take an older property and catch up on your savings. In essence, you gain the benefits of the years you did not use this service. There is a point, however, at which the age of the property eliminates the need for cost segregation.

While the value conclusions of a recently completed valuation of more than 140 self-storage facilities or acquisition are proprietary, we can share with you the basic results. The percentage of the purchase price that was allocated to short-lived properties varied between a low of five percent to a high of 33 percent. Most were near the 20 percent range. The size of the parcel as a whole was generally two times that of the buildings.

Determining Market Value
Following an acquisition, you may be required to have an appraisal completed for Purchase Price  Allocation, defining the basis of value for the land versus the improvements. Below for your  consideration is the definition of “Market Value” and a introduction to the three approaches to value used to derive the market value of a property.

Market Value (Appraisal Foundation) --
The most probable price which a property should bring in a competitive and open market under all  conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and
assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

• Buyer and seller are typically motivated:
• Both parties are well informed or well advised, and acting in what they consider their best interests;
• A reasonable time is allowed for exposure in the open market;
• Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
• The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

Market Value is synonymous with the legal term, “Fair Market Value.” Many of the major CPA firms are  requiring that all three approaches to value be used as part of the study to estimate Market Value,  these approaches, as generally defined, are below.

• Cost Approach – This approach considers the current cost of reproducing a property, less its accrued depreciation. A summation of the market value of the land assumed vacant and the depreciated reproduction or replacement cost new of the improvements provides an indication of the total value of the property.
• Sales Comparison Approach – This approach produces an estimate of value by comparing the sales and/or listings of similar properties in the same area or in competing areas. This technique can indicate the value established by informed buyers and sellers in the market.
• Income Capitalization Approach – This approach is based on an estimate of the subject property’s possible net operating income (NOI). The NOI is capitalized to arrive at an indication of value from the standpoint of an investment. This method measures the present worth of anticipated future net income from the property.

So what exactly are the benefits of cost segregation? With so may variables, there is no simple  answer. In your first year, you can get back roughly 50 cents per square foot of construction as  savings. Hence, for a 100,000 square-foot building, you would expect savings of around $50,000, although it could be more and it could be less. After five years, the savings begin to drop since the five-year property has fully depreciated.

Just a warning: when a cost segregation firm “guarantees” their results—be careful. As you can see  from the real-life examples, the range of findings could vary significantly.

A quality cost segregation study takes only a few weeks to complete but it can benefit the business owners for years. And it can cost only a fraction of the long-term tax savings that will be realized. If cost segregation isn’t a process you’re taking advantage of with your self-storage business, you could easily be paying more in federal income taxes than is required.

This article was originally published in the November 2007 edition of the Mini-Storage Messenger. This article has been reformatted to fit within the confines of this Web page.