If you are searching for new strategies for increasing your facility’s cash flow (and who isn’t?), it may be time to look into cost segregation. While it is not a new idea, it may be new to you. If, however, you are constructing a new building for your practice, an ambulatory surgery center or other facility, or if you are purchasing an existing building, this tool may reduce current income tax liabilities and add cash to your bottom line.
The time value of money
In healthcare, the expression “time is money” has never been more true than it is today. The evolution of how physicians are compensated for the care they provide has made medical professionals increasingly aware of the importance of the value of their time. Professionals who start or purchase a practice become business owners—particularly if they purchase or construct a building to house that practice—and are challenged to make more complex financial decisions that require a deeper understanding of the relationship between time and money.
That understanding begins with the realization that a dollar that you have in your pocket right now has more value today than it will have tomorrow. “Its value depends upon when it is received or paid, and that differential is called ‘the time value of money,’” says Stephen Sheppard, Managing Principal of Medical Consulting Group, LLC. “A tax deduction also represents money that has more value this year than it will have next year, and far more value than it will have 39 years from now.”
Why is that number significant? Prior to 1987, the IRS specified a 39-year depreciation schedule for real property. Personal property could be depreciated more quickly. Since 1987, however, the IRS has recognized that property consists of several asset types with different recovery periods. As a result, its components can be segregated into asset classes according to the appropriate recovery period and placed-in-service dates, for the purposes of calculating depreciation.
How cost segregation works
A cost segregation analysis involves identifying and reclassifying components and assets of your facility to take the fullest possible advantage of opportunities afforded by the Modified Accelerated Cost Recovery System (“MACRS”) to reduce current income tax burdens. A building is still depreciated over a period of 39 years, yet certain components of that building—its roof, for example—cannot be expected to last as long as the building itself, and other components attached to the property, such as sidewalks and fencing, have a shorter life, too, and can be depreciated over a shorter period of time, typically 5, 7, or 15 years. Certain other specialized components built into a structure, such as reinforcement to support the weight of heavy equipment, the specialized wiring needed to power that equipment, or enhancements to a climate control system necessary to keep the equipment cool, may also qualify for a shorter recovery period.
“As a practical matter, it’s often easier to properly document this segregation during new construction,” says Sheppard, who is also a CPA and has been involved in the development and management of many ambulatory surgery centers. “However,” he adds, “thanks to a further modification of the rules in 1996, an existing property you own or lease may also qualify.”
A purchaser is now permitted to backtrack as far as 1987 to correct the tax lives of certain assets, such as furniture, fixtures, and equipment that could have taken advantage of MACRS. The IRS automatically approves requests from taxpayers to change their depreciation accounting method, making it possible for them to take advantage of accelerated depreciation of segregated assets. The resulting difference from past years can be written off as a lump sum during the current year, without going back and amending returns. Likewise, there may be opportunities to backtrack and take advantage of savings after selling a property.
The savings can be considerable.
As a rule of thumb, assuming a 35% marginal tax rate and a 5% discount rate, each $1,000 in assets moved from a 39-year recovery period to a five-year recovery period can be expected to yield tax savings with a present value of $160.
Consider this example, based on an actual cost segregation study1:
|Non-residential building purchase price: $12,135,000.Depreciation without cost segregation: 39 years straight-lineAssumptions: 35% tax rate, 5% discount rate
The engineering consultant’s report classifies:
Accelerated depreciation on the 5-year and 15-year property yields $133,563 in present-value tax savings.
The resulting additional cash flow can provide capital for other investments in the practice or elsewhere.
This is NOT a do-it-yourself project
IRS guidelines require that assets must be assigned to proper asset classes, and the correct method and property recovery period must be used for each asset. An engineered approach coupled with tax accounting experience is recommended. In addition, purchase price allocations of an acquired (purchased) property will also require the expertise of an appraiser and valuations expert.2
In other words, a cost segregation analysis should not be viewed as a do-it-yourself project. The good news is that there’s no shortage of consulting firms that specialize in comprehensive cost segregation services and are able to provide a solid analysis that can stand up to IRS scrutiny. The costs of these services vary, but they typically yield savings that pay for the study many times over. As with many other things, you must spend money to save money.
Many can benefit, but it’s not for everyone
You should give cost segregation serious consideration if your plans involve a ground up construction project, and you may still benefit if you will be making improvements to a property that you lease. Consult a CPA tax specialist who can perform a dynamic break-even analysis that will look at a number of factors to determine if cost segregation makes sense for you in your situation.
Size matters. “Unless your project will cost at least $3 to 4 million, the expense of a segregation study may overshadow the benefits,” Sheppard adds. “Timing makes a difference too. It’s not unusual for a new practice to accumulate a large operating loss during year one, when its revenue stream may be out of sync with the steady stream of patients. You probably won’t need the type of tax deduction that results from cost segregation until you have more taxable income.”
The legal personality of your practice will also be a factor. An LLC, for example, is a pass-through entity that does not pay tax. If you have partners, their individual tax positions must be taken into consideration—just one more reason why you need a tax specialist on your team.
If you decide to pursue a cost segregation strategy, that tax specialist and your lender may be able to help you select a consulting firm that can analyze component assets and provide you with the documentation you will need to take advantage of these tax savings.
- Soled, Jay A., and Falk, Charles E., “Cost Segregation Applied.” Journal of Accountancy, August 2004. www.journalofaccountancy.com/issues/2004/Aug/CostSegregationApplied.htm
- Internal Revenue Service, “Cost Segregation Audit Techniques Guide.” IRS.gov.