Benefits of Cost Segregation on Cancer Treatment Facilities

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1 WHITE PAPER: Benefits of Cost Segregation on Cancer Treatment Facilities Executive Summary Appropriately conceived and implemented tax strategies create direct measurable financial benefits on the total cost of construction and ownership of new and expanded Cancer Treatment Facilities. One historically underused way to off-set costs and enhance cash flow is to reduce federal income taxes through legitimate IRS-guided methods. Often, owners, investors and operators of health care facilities do not optimize the opportunity allowed under current laws and meaningfully overpay federal income tax. Incorporating cost segregation, particularly fully detailed engineering based cost segregation, into the construction/expansion process can help as demonstrated in two examples. Cost Segregation: Cost segregation, is an IRS-compliant method to separately recognize and accurately account for the costs of 3-, 5-, 7-, 10- and 15-year property from the 27.5-/39-year property classifications in a commercial property. Once properly identified, those items in each class from 3-15 years are eligible for accelerated depreciation. This allows a Federal income tax paying business, institution or organization to further increase deductions during the early life of the ownership and operation of a commercial property. Specifically, a cost segregation study of a commercial property is: A detailed review and analysis identifying all components, their costs and classification for accelerated depreciation Performed by experienced, uniquely qualified engineers and tax experts Conducted to meet or exceed IRS published guidelines and standards Based on construction drawings, cost data and a comprehensive site inspection by experts Certified by an individual reviewer Among the benefits of a cost segregation study are an immediate increase cash flow due to a supportable reduction in reportable income and federal income taxes paid following an increase in accelerated depreciation. Additionally a properly done study provides the detail necessary to later retire long-term assets when items are replaced. Instances where a cost segregation study yields substantial benefits include new construction, property acquisition and leasehold improvements. Nearly every commercial property can generate tax benefits for its owner from legitimate acceleration of depreciation with cost segregation. The benefit amount depends on the property type. Owner qualifications to capitalize are modest: the owner must be a federal income tax payer of a commercial property with a value (excluding land) of $1 million or more (or leasehold improvements of $500,000+). Notably, the tax benefits can be estimated before doing a cost segregation study Two case study examples demonstrate the value of employing cost segregation as a regular integrated part of the construction/expansion process: with cost segregation, a newly constructed $3 million cancer treatment facility yields over $230,000 in first year cash flow/after tax benefits, while a $900,000 center expansion produces about $120,000 in first year benefits. Additionally, employing the most rigorous approach as we recommend, the center owners are given access to another set of deductions to be used in the retirement of long-term assets of about $600,000 and $116,000, respectively. Architection works closely with a dedicated team of engineers and tax experts specializing in engineering-based cost segregation studies. This is the most conservative approach, yet yields the highest amount of legitimate accelerated depreciation benefits plus additional deductions from the retirement of long-term assets. These experts have performed over 8,000 cost segregation studies that generated hundreds of millions of dollars in tax benefits. There is a free, no obligation initial assessment that determines qualification while providing a conservative estimate of a study s benefits and its costs See how to increase your cash flow: get this free analysis by contacting Jeff Liebert ( ) or Phil Muldoon ( ) jeff.liebert@neacelukens.com philip.muldoon@neacelukens.com

2 What is Cost Segregation? Cost Segregation is a strategic, IRS-compliant approach to reduce tax payments by appropriately accelerating depreciation. This tool allows owners to maximize the depreciation deductions of their commercial property. Most businesses already understand and take advantage of the deductibility of the readily identified personal property items in their operations (like furniture, fixtures and equipment). However these readily identified items often account for a small part of a commercial property s total cost, meaning that most of these costs are depreciated over 27.5 or 39 years. Cost segregation more accurately categorizes a building s components (including its plumbing, electrical and mechanical infrastructure) to substantially increase cash flow by expanding depreciation deductions, lowering reportable income and income taxes. This is allowable only after a comprehensive study of the costs incurred to build, acquire or renovate a commercial property by experts trained and experienced in engineering and taxes. Many physical components of a commercial property entitled to accelerated depreciation are not typically identified in a standard appraisal. A cost segregation study identifies individual assets, their associated costs and appropriate recovery period for taxation purposes. What are the Benefits of a Cost Segregation Study? Most immediately, cost segregation: Generates an immediate increase in cash flow through accelerated depreciation deductions Reduces income taxes Provides an easy opportunity to claim catch up depreciation on previously misclassified assets Provides an independent third-party analysis that will withstand IRS review Other valuable benefits include: Allows write-off of replaced assets (without specific identification of building components, the IRS requires continued depreciation of replaced items like a roof or HVAC system over the building s longer life ) Complements the new construction design process to lower the cost per square foot Lowers other costs (insurance) and taxes (real estate) Enhances bank loan qualifications Bridges the gap between engineering, construction and accounting systems Allows for possible refunds on prior taxes paid Where Does Cost Segregation Apply? What is Required to Benefit? There is an array of commercial properties where cost segregation applies: New construction Property acquisition Leasehold improvements Notably, the property owner s tax status also must be considered as the owner must pay or intend to pay taxes. Specific owner requirements include: Own a commercial property with a value of $1 million or more OR with leasehold improvements of $500,000+ Pay federal income taxes or have paid federal income taxes in the last year Operate as a for-profit entity Plan on keeping the property for at least one year Importantly, 90+% of qualifiers realize sizable tax benefits from a cost segregation study. What is Involved in a Cost Segregation Study? In the words of the IRS, a quality study must be conducted by specialists with experience and knowledge in engineering, construction and taxation. Properly done, these experts perform a non-intrusive, yet detailed engineering-based exam of a commercial property s walls, flooring and ceiling including its plumbing, electrical, lighting, telecom, heating and cooling systems. Acting in collaboration with the owner s CPA or tax accountant to identify/classify all components in 3-, 5-, 7-, 15-, and 27.5-/39-year asset classes, studies typically involve: A site visit verifying the condition, functionality and existence of assets, Examination, review and analysis of all relevant building drawings and specs including: o Copies of as-built drawings, including a site survey with a legal description o Property-condition reports, purchase agreements and appraisals to corroborate evidence when original construction documents are not available, o General contractor/subcontractor payment applications and owner invoices for other work performed/ items purchased, o Depreciation schedules to verify property treatment, Interviews with contractors, property managers and others to determine the property s specific use Using the information gathered, the experts o Perform quantity takeoffs of the property from drawings (or estimates if drawings unavailable) o Estimate current cost of assets using recognized cost sources o Adjust current replacement cost to account for physical deterioration/functional obsolescence o Tie findings and estimates to taxpayer s tax basis

3 What Building Components are Commonly Reclassified? Examples of personal property in building components that can be the source of accelerated depreciation: millwork, decorative items, land improvements, special pipes/plumbing, special electrical, emergency lighting, site utilities, site lighting, concrete drains, signage, window coverings, demountable partitions, paving/sidewalks, carpet/vinyl tile, security systems, fume exhaust systems, vinyl wall coverings, phone/data/tv wiring and intercom systems. What Property Types Benefit from Cost Segregation? Nearly every commercial property can generate tax benefits for its owner from legitimate acceleration of depreciation with cost segregation. The benefit amount depends on the property type. Some example average percentage of building components qualifying for accelerated depreciation among health care commercial properties include: Medical Offices, 20% - 50%; Research & Development facilities, 20% - 60%; and Hospitals, 20% - 50%. How Does Cost Segregation Find Tax Benefits for Commercial Property Owners? For Federal income tax purposes, building costs are generally classified into three categories. Under the applicable depreciation method used, called Modified Accelerated Cost Recovery System (MACRS), each category has a different depreciation recovery period and method: Property Classification Years Depreciation Method Tangible Personal Property 5 or 7 Years 200% Double Declining Land Improvements 15 Years 150% Double Declining Real Property 27.5 or 39 Years Straight-Line Cost segregation identifies all building components that can legitimately be classified as tangible personal property or land improvements. Thus, these items are depreciated faster than over 39-years and typically translate to tax benefits in the first tax year after the study. The tax/cash benefits over the life of the property ownership can total in the hundreds of thousands of dollars. For example following a study, a taxpayer that owns a cancer treatment facility can legitimately classify the cost of certain equipment foundations, exhaust and ventilation systems, security systems and electrical distribution as tangible personal property. Also, site improvements like landscaping, underground utilities and site lighting qualify as land improvements. Depreciation on these items can be accelerated for tax and cash flow benefits (see detailed examples that follow). Knowing the intricacies of building components and how each can be legitimately classified is critical. So is the ability to support and document the conclusions and classifications made. That is why expert advice is a necessity. Identification of items to be reclassified must be accompanied by determination of the costs legitimately associated with each item. There is particular complication in determining single-item costs. For example, suppose part of a facility s electrical distribution supports specific equipment and legitimately qualifies for shorter-life classification. Often contractors records of charges bundle all electrical-related costs into a single line item. To comply with IRS requirements, there must be a means to identify only the costs of the part of electrical distribution serving the equipment. Cost segregation experts can readily unbundle these costs and assign them appropriately not only the direct cost, but also any indirect costs that apply (e.g. architect and engineering fees, contractor s general conditions, permits and bonds). This requires extensive knowledge of and experience in construction methods, engineering, AND the Internal Revenue Code (including applicable tax court cases and IRS rulings). Thus the unique combined expertise of reading blueprints plus full understanding of construction materials, costs as well as taxation is necessary. Can the Tax Benefits be Estimated BEFORE doing a Cost Segregation Study? Yes, a benefit analysis is performed in advance to estimate a study s tax/cash flow benefits. Information required to prepare a benefit analysis include the property s latest depreciation schedule and certain support documentation. After the experts evaluate this information, an estimate of a study s anticipated benefits is developed; this estimate includes the fees anticipated to do the study. Notably, benefit analysis identify significant tax and cash flow benefits 95+% of the time. Also, the cost of a study usually is a fraction of the benefits realized. When is the Best Time to do a Cost Segregation Study? Optimally, a study should be conducted as the asset is purchased, constructed or improved and placed into service. However a study can be performed anytime. IRS guidelines include straightforward means to immediately catchup a property s understated depreciation from past years without amending prior tax returns. How Long Does a Study Take? What is Included in the Final Report? Cost segregation studies for existing properties usually are finished in four to six weeks, depending on the size and complexity of the building(s). Studies of newly built properties proceed with the pace of construction. On completion, a detailed, engineering-based study produces a comprehensive written narrative report listing and classifying all building(s) components. Notably, this report is a complete, clear paper trail reconciling to the building(s) cost basis and substantiates and documents its classifications and conclusions to provide the property owner/his tax consultants the information and support to properly depreciate all building components.

4 What is Expert Opinion on Cost Segregation? The U.S. Treasury Department States: Cost Segregation is a lucrative tax strategy that should be used in almost every major purchase of commercial real estate. Wall Street Journal A Cost Segregation Study, for either new construction or recently completed projects, can significantly improve the financial viability of a project by accelerating depreciation deductions, as well as improving return on investment. Accounting Today Whether an investor is constructing, purchasing or expanding a building, a cost segregation study can significantly increase cash flow by accelerating tax deductions. Baltimore Daily Record A cost-segregation study is a valuable tax strategy for taxpayers who currently own, are constructing or renovating, or who are acquiring real estate. The reason is simple: tax deductions for depreciation are taken earlier, which translates into a present-value, cash flow benefit." -AICPA (American Institute of CPAs) "Cost- Segregation Studies: Good News for Clients" What Laws, IRS Regulations and Court Cases Govern Cost Segregation? The legislation and procedures used in cost segregation studies existed since enactment of the Investment Tax Credit (ITC) in With the act s repeal in 1986, it was generally assumed that cost segregation no longer could be used for tax benefits. However, in a landmark 1997 tax court case, Hospital Corporation of America (HCA) successfully defended cost segregation as a viable means to differentiate real and personal property under existing law. Since the HCA decision, the IRS made several significant rule and procedural changes to ease use and submission of cost segregation studies, maximizing the benefits property owners can realize from accelerated depreciation: In 2002, the IRS consented to a simpler means to account for changes in the method of depreciation. Subsequently, by filing a Form 3115 with the return in the year the change is elected, taxpayers can alter their method of depreciation as determined in a cost segregation study without filing an amended return. Rev. Procedure Following the 9/11 tragedy, the Federal government allowed taxpayers to catch up on all deductions from prior years for items reclassified into shorter tax lives with a cost segregation study. Rev. Procedure In 2004, the IRS reversed the 2 year waiting period required to change the method of calculation for depreciation on property. Thus, taxpayers can change the method of depreciation in any year and receive benefits immediately. Rev. Procedure In 2004, the IRS published its Cost Segregation Audit Techniques Guide. This Guide provides specific criteria and audit practices to evaluate the conduct of and the actual documentation contained in a cost segregation study. This publication and IRS practices firmly established engineering-based cost segregation as the primary and preferred method for classifying property for determining taxpayer depreciation practices. Cancer Treatment Center Case Studies Below and on the following page are descriptions and details of two examples that clearly demonstrate the meaningful positive impact of cost segregation when implemented as a regular part of the planning and construction of cancer treatment centers: New 10,000 Square Foot Free Standing Cancer Treatment Center: During construction of a new $3 million facility, a concurrent cost and engineering analysis of the construction documents, payment applications, blueprints, and change orders is coupled with an onsite inspection. This study results in a comprehensive identification of all structural building components, land improvements and personal property assets. Consequently and in contrast to what can be done without a study, 27% of the facility s total cost can be classified as personal property and another 7% as land improvements. This accurate classification of all of the facility s components results in cash flow/after-tax benefits of over $230,000 in the first year. For perspective, this amount is comparable to this project s first year financing charges. Additionally, over the tax life of the cancer treatment center, the owner realizes a present value after-tax benefit of approximately $240,000. Finally, as we recommend, if a fully detailed study classifying all building components is performed, the owner has access to another $598,000 in deductions over the life of the facility to be used in the retirement of long-term assets when they are replaced. Small Treatment Center Vault Addition: Similar favorable impacts of cost segregation are realized (on a smaller scale) when applied within the process of expanding an existing cancer treatment facility. In the instance of a $900,000 expansion, the experts detailed examination of this addition means that 55% (or $495,000) of its total cost is more accurately classified as 5-year personal property, while another 2% (or $18,000) is classified as land improvements (15-year property). Consequently in comparison to the circumstances with no study, the owner reaps nearly $120,000 in first year cash flow/after-tax benefits and approximately $127,000 in present value benefits over the life of the facility. Further, for future use in the retirement of long term assets, the cost segregation study provides the owner access to another $116,000 in deductions.

5 Cost Segregation Benefit Analysis Case Studies Cancer Treatment Center (50% Bonus) Cost Basis (ex land) is $3,000,000; Put into Service in 2012 ALLOCATION COMPARISON BEFORE & AFTER COST SEGREGATION Classification Current Allocation % Allocation w/css % 39-Year Property $3,000, % $1,995,000 67% 15-Year Property $0 0% $195,000 7% 7-Year Property $0 0% $0 0% 5-Year Property $0 0% $810,000 27% TOTAL $3,000, % $3,000, % PROJECTED BENEFITS & RETURN ON INVESTMENT Holding Period Accelerated Expected Cash Depreciation Benefit Net Present Value Anticipated ROI Current $575,491 $230,196 $230, : 1 Next 5 Years $808,575 $323,430 $310, : 1 Next 10 Years $708,535 $283,414 $289, : 1 Life of Property $0 $0 $240,029 (2051) 32 : 1 These benefits are for regular income tax purposes and are based upon a federal income tax rate of 40%. These benefits are estimates only. While we anticipate your results will exceed this estimate, your actual benefits may be higher or lower than this illustration. PROFESSIONAL FEES: $12,500 NET COST AFTER TAXES: $7,500 With a fully detailed, engineering based study as we recommend, every building component is classified. This provides added benefits as any 39-year component can be written off when replaced. Research indicates up to 30% of 39-year assets are replaced over a commercial property s depreciable life. Potential Added Write-offs: $598,500 Cancer Treatment Center Renovation (50% Bonus) Cost Basis (ex land) is $900,000; Put into Service in 2012 ALLOCATION COMPARISON BEFORE & AFTER COST SEGREGATION Classification Current Allocation % Allocation w/css % 39-Year Property $900, % $387,000 43% 15-Year Property $0 0% $18,000 2% 7-Year Property $0 0% $0 0% 5-Year Property $0 0% $495,000 55% TOTAL $900, % $900, % PROJECTED BENEFITS & RETURN ON INVESTMENT Holding Period Accelerated Expected Cash Depreciation Benefit Net Present Value Anticipated ROI Current $299,874 $119,949 $119, : 1 Next 5 Years $435,605 $174,242 $167, : 1 Next 10 Years $372,495 $148,998 $153, : 1 Life of Property $0 $0 $126,601 (2051) 20 : 1 These benefits are for regular income tax purposes and are based upon a federal income tax rate of 40%. These benefits are estimates only. While we anticipate your results will exceed this estimate, your actual benefits may be higher or lower than this illustration. PROFESSIONAL FEES: $10,500 NET COST AFTER TAXES: $6,300 With a fully detailed, engineering based study as we recommend, every building component is classified. This provides added benefits as any 39-year component can be written off when replaced. Research indicates up to 30% of 39-year assets are replaced over a commercial property s depreciable life. Potential Added Write-offs: $116,100