Why A Cost Segregation Study Is A Good Idea — Accelerate Depreciation Deductions To Reduce Taxes And Boost Cash Flow

Mark Thomson | Ostrow Reisin Berk & Abrams

The COVID-19 pandemic has resulted in many companies conserving cash and not buying much equipment during the past year. An unintended downside is that you may not be able to claim the same amount of depreciation tax deductions as you have in past years.

What can you do? A cost segregation study may allow you to accelerate depreciation deductions on certain items, thereby reducing taxes and boosting cash flow. And, thanks to the Tax Cuts and Jobs Act, the potential benefits of a cost segregation study are now even greater than they were a few years ago because of enhancements to certain depreciation-related tax breaks.

Related Read: Using Cost Segregation Studies for Like-Kind Exchanges

DEPRECIATING PROPERTY

Business buildings generally have a 39-year depreciation period (27½ years for residential rental properties). Typically, companies depreciate a building’s structural components — including walls, windows, HVAC systems, plumbing and wiring — along with the building. Personal property (such as equipment, machinery, furniture and fixtures) is eligible for accelerated depreciation, usually over five or seven years. And land improvements, such as fences, outdoor lighting and parking lots, are depreciable over 15 years.

Often, businesses allocate all or most of their buildings’ acquisition or construction costs to real property, overlooking opportunities to allocate costs to shorter-lived personal property or land improvements. Items that appear to be “part of a building” may, in fact, be personal property.

Examples include:

  • Removable wall and floor coverings;
  • Removable partitions;
  • Awnings and canopies;
  • Window treatments;
  • Signs; and
  • Decorative lighting.

In addition, certain items that otherwise would be treated as real property may qualify as personal property if they serve more of a business function than a structural purpose. Examples include reinforced flooring to support heavy manufacturing equipment, electrical or plumbing installations and dedicated cooling systems for equipment or server rooms.

CALCULATING COSTS

Under the right circumstances, a cost segregation study can yield substantial tax benefits. A cost segregation study identifies real estate components that are properly treated as personal property depreciable over, say, five or seven years, or land improvements depreciable over 15 years. By allocating a portion of your costs to these shorter-lived assets, you can accelerate depreciation deductions and substantially reduce your tax bill. And, do not overlook bonus depreciation. If these assets qualify, the tax savings can be even greater.

Bear in mind that tax law changes may occur this year that could affect current depreciation and expensing rules. This, in turn, could alter the outcome and importance of a cost segregation study.

CONDUCTING THE STUDY

A cost segregation study should be performed by an outside, independent firm. According to the IRS Cost Segregation Audit Techniques Guide, there are no prescribed qualifications for cost segregation preparers. The guide, however, states that a study conducted by a construction engineer would, all else being equal, be considered to be more reliable than one performed by someone without a construction background.

The guide further states that other important criteria include “experience in cost estimating and allocation, as well as knowledge of the applicable law.” It adds: “A quality study identifies the preparer and always references their credentials, experience and expertise in the cost segregation area.”

REWARDING TAX BENEFITS

Though the relative costs and benefits of a cost segregation study will depend on your particular facts and circumstances, it can be a valuable investment. Cost segregation studies have costs all their own, but the potential long-term tax benefits may make it worth your while to undertake the process. Contact your ORBA CPA for further details.

Why is the Carrier so Quick to Argue the Wear and Tear Exclusion?

Nicole Vinson | Property Insurance Coverage Law Blog | June 26, 2019

Chip Merlin posted about the Wear and Tear Exclusion just last month in Wear and Tear Exclusions Versus Depreciation For Resulting Damage To Worn and Torn Older Parts of a Structure. Explaining about wear and tear, Chip gave this example:

The judge made up his own example of ten old bolts giving way and then the rest of what the bolts failed to hold up, crashed and broke the rest of the old structure. The worn-out bolts may not be covered, but if you have the right ensuing loss provisions after the “wear and tear” clause, the rest of the loss is covered—even if the rest is old.

The older parts of the structure are the ensuing loss. They did not suffer a loss because they were worn out and broke. They suffered a loss because other parts of the structure broke from “wear and tear.” Those ensuing parts of the loss are depreciated on an actual cash value basis. If replaced, they are then valued at Replacement Cost.

This is such a hot topic because so many times we see the wear and tear policy language listed (often improperly) in a denial letter. If you are policyholder who receives a letter that says, here is a small payment or we are not paying your claim, it is not uncommon to see the wear and tear provision quoted in the list of “reasons.” Frequently this language is cut and paste from the insurance policy and looks very official. But does it really apply?

The distinction Chip pointed out above is very important, but carriers sometimes even list the wear and tear exclusion in cases where the cause of the damage was a peril like wind, fire, theft, or vehicle impact.

Javier Delgado of Merlin Law Group often reminds us to look at the policy language specifically written about the exclusions as will likely be language that says something similar to, “Exclusions… caused by:” and then a laundry list of reasons. The “caused by” requirement cannot be forgotten.

When a property with some age and bruises suffers any peril (we will use a hurricane as an example) the caused by language cannot be overlooked. That property invariably had some wear and tear to its roof before the hurricane winds impacted the property. This is very common.

Take a look around the building you are in and you will see signs of wear and tear. Look at your office and your own home. You will see the condition is likely not brand new. But this condition of the property did not cause the property to lose the roof in Hurricane Michael. The wind caused the damage to the roof.

When a sudden and accidental loss happens to your property that is not brand new, everything all together is not excluded because of a wear and tear exclusion in a policy.

And insurance companies contemplate that the property they are insuring is aged or will have some battle scars. Just look at the underwriting file. The premium may have been calculated, in part, based on the year of construction.

The condition of the property, and the wear and tear, is considered when the adjuster applies depreciation. Say it with me again. When wear and tear exists but is not the cause of the loss, wear and tear of the property is considered when depreciation is applied.

This analysis is taken further in Chip’s post about the ensuing loss and resulting loss issues.

The Insurance Coverage Law Center explained:

Wear and Tear was written into policies to let the insured know that the insurance is not for claiming things that reach their natural life span. Property insurance and a maintenance contract are very different. “The purpose of a wear and tear, marring and gradual deterioration is to exclude maintenance type loss that naturally occur over time… to eliminate insurance recovery in situations where claim is made on property, which has been damaged through normal use, abuse or has simple been ‘used up’.”

If you are a public adjuster, insurance agent or an insurance adjuster trying to wrestle with a hard to understand coverage provision and not make a wrong decision, Chip explained: Insurance is important. We defeat its purpose with over-broad use of exclusions.

So, to answer the question, why is this exclusion being used so often, it may very often be improperly cited as an exclusion. Remember to check the grant of coverage, the exceptions to the exclusions, and the ensuing loss and resulting loss coverage.

For more insight on why carriers may have listed the exclusion in your claim, take a look at the resources in FC&S Bulletins, their website, and Bill Wilson’s book, When Words Collide: Resolving Insurance Coverage and Claim Disputes.

And a quick note about the Insurance Coverage Law Center, (formerly FC&S Legal), it states that it,

[D]elivers the most comprehensive expert analysis of current legal and policy developments that insurance coverage attorneys rely on to provide daily actionable counsel to their clients.

The Insurance Coverage Law Center is part of the National Underwriter authoritative insurance portfolio developed more than 80 years ago. ICLC ensures attorneys practicing insurance coverage law, or business professionals wishing to keep apprised of the latest industry developments, have access to a single source of objective legal analysis, practical insights, and news for the insurance industry.

Today, our team of experts continues to provide objective insights and analysis, particularly in the area of policy interpretation, to meet the insurance law information needs of busy legal professionals working in private practice or in-house and representing either policyholders or insurance carriers.

Applying Depreciation in California – Understanding the Guidelines

Victor Jacobeills | Property Insurance Coverage Law Blog | March 26, 2019

The California Insurance Code mandates if a property insurance policy requires actual cash value payment, the payment must be based on the property’s depreciation for two types of claims: (1) a partial loss to a structure, i.e., a home or building and (2) damaged contents, i.e., personal property or business personal property.1 Fortunately, there is guidance on how depreciation is applied. Cal. Ins. Code § 2051 states actual cash value is the amount it would cost the insured to repair, rebuild, or replace the damaged property less a fair and reasonable deduction for physical depreciation based upon the property’s condition at the time of the injury or the policy limit, whichever is less.

The California legislature is currently debating legislation, Assembly Bill 188, that would require an insured be paid in the same manner for the total loss of a building, as an insured is paid for a partial loss of a building, i.e., for the building’s actual cash value.

Cal. Ins. Code § 2051 and Cal. Code Regs. tit. 10, § 2695.9, set forth parameters on depreciation application and require that depreciation reflect damaged property’s actual condition at the time of a loss. Under Cal. Ins. Code § 2051, physical depreciation can only be applied to the components of a structure that are normally subject to repair and replacement during the useful life of that structure. Under this statute, an insurer can only apply depreciation to building components that are expected to actually suffer wear and tear. The threshold question before depreciation can be applied is whether the component is normally replaced by the home or building owner. If it is not a component that is replaced, what is the extent of maintenance necessary to keep the component in a good condition? For example, a building’s foundation, structural elements, walls and piping are usually not replaced and it is therefore improper to apply any depreciation. It is also improper to apply depreciation to any cost in a building repair estimate that does not relate to building property. Thus, an insurer cannot make depreciation deductions for labor, plans, permits, overhead and profit. If a building component requires minimal maintenance, then the amount of depreciation that can be applied should be limited. For example, a brick wall will probably never be replaced, but it could be subject to some maintenance every ten to twenty years.

California also requires that depreciation cannot be applied based solely on a building component’s age. California insurance regulations mandate that any adjustment for depreciation must reflect the measurable difference in market value attributable property’s age andcondition.2 Consequently, depreciation must be based on the actual condition of the damaged property. Factors that should be considered include how the insured maintained the property, when was the building component last replaced and what was the quality of the property or component. If you can substantiate the property was in good to excellent condition, then you can substantiate minimal depreciation deductions.

Based on California’s depreciation guidelines, in order to correctly evaluate the proper amount of depreciation to apply, it is very important to asses and evaluate the condition of the property prior to the loss. This includes gathering as much information from an insured whether through photos, the insured’s contractors or detailed oral information. This information will assist in minimizing and correctly assessing depreciation.
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1 Cal. Ins. Code § 2051.
2 Cal. Code Regs. tit. 10, § 2695.9.


Federal District Court Weighs in on Whether Labor Can Be Depreciated in Arriving at an Actual Cash Value Loss Settlement

Edward Eshoo | Property Insurance Coverage Law Blog | December 7, 2018

Whether labor can be depreciated in arriving at an actual cash value property loss settlement has been a hot topic of debate over these past five years. A federal district court in Ohio recently weighed in on the issue in ruling on motions to dismiss two putative class action lawsuits, one against State Farm Fire & Casualty Company1 and one against Allstate Indemnity Company.2

The insureds in both cases challenged whether labor could be depreciated in arriving at an actual cash value settlement. In concluding that it was proper to do so, resulting in the dismissal of the lawsuits, the district court reasoned that the term “actual cash value,” which was undefined in the State Farm and Allstate policies, meant replacement cost less depreciation and that the plain and ordinary meaning of the term “depreciation” was inclusive of labor. The district court also found persuasive those decisions from other courts that had likewise found that labor should be included in depreciation.3

The results reached in Perry and Cranfield are contrary to the results reached in Hicks v. State Farm Fire & Casualty Company,4 and Titan Exteriors, Inc. v. Certain Underwriters at Lloyd’s, London,5 two recent decisions in which the Sixth Circuit Court of Appeals and a federal district court sitting in Mississippi concluded that labor costs should not be depreciated in arriving at an actual cash value settlement using a replacement cost less depreciation formula. Unlike the district court in Perry and Cranfield, the courts in Hicks and Titan Exteriors found no reason to decide which of the competing legal decisions were correct. Instead, they concluded that all of the interpretations offered by courts considering the labor depreciation issue were reasonable, rendering the term actual cash value ambiguous when defined as replacement cost less depreciation.

While the labor depreciation issue is an interesting legal debate, insurers can put this debate to rest simply by drafting its policy like State Farm has done in its “Actual Cash Value Endorsement” to clearly and unambiguously state that labor is subject to depreciation.6 Until they draft their policies to reflect their intent for labor to be subject to depreciation, insurers will be left to deal with decisions like Hicks and Titan Exteriors.
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1 Cranfield v. State Farm Fire & Cas. Co., No. 1:16-cv-1273, 2018 WL 6162900 (N.D. Ohio Nov. 26, 2018).
2 Perry v. Allstate Indem. Co., No. 1:16-cv-01522, 2018 WL 6169311 (N.D. Ohio Nov. 26, 2018).
3 The district court referred to these cases as the current majority view among state and federal courts. But, as the Hicks court observed, these cases are not similarly situated. Many of them were not decided using the replacement cost less depreciation formula; instead, they employed the broad evidence rule, or some form of fair market valuation. Seee.g.Wilcox v. State Farm Fire & Cas. Co., 874 N.W.2d 780 (Minn., 2016) . Under both the market value test or the broad evidence rule, all relevant evidence is considered in in calculating actual cash value.
4 Hicks v. State Farm Fire & Cas. Co., No. 18-5104, 2018 WL 4961391 (6th Cir. Oct. 15, 2018).
5 Titan Exteriors, Inc. v. Certain Underwriters at Lloyd’s, London, 297 F. Supp. 3d 628 (N.D. Miss. 2018).
6 Under this endorsement, all components of the estimated actual cash value, defined as the estimated cost to repair or to replace damaged property, are subject to depreciation, including labor, materials, taxes, and overhead and profit.

Explaining Depreciation of Personal Property Contents in Colorado

Jonathan Bukowski | Property Insurance Coverage Law Blog | April 14, 2018

Whether your insurance company forced you to sift through soot and ash, trying to recollect what has just been stolen, or trying to identify items damaged by water, going through damaged contents and creating an inventory is an emotionally draining experience that typically comes with little to no guidance by the insurance company. After spending countless hours substantiating lost personal property contents, the insurance company responds with random, and sometimes substantial reductions in the value of the personal property for depreciation, often with little to no explanation as to how it arrived at that conclusion.

But what is depreciation, and why is it important?

Depreciation is the loss in value to a particular item due to wear and tear, age, obsolescence, or any other factor. Depreciation is subtracted from the cost to replace the damaged items to arrive at an actual cash value. While most insurance policies provide for recovery based on a replacement cost basis, some policies limit recovery of personal property contents to the actual cash value. It is also common for replacement cost value policies to limit recovery to actual cash value until the damaged property is repaired or replaced. While it may not be difficult to replace an inexpensive item that has been substantially depreciated, it can become very difficult, or nearly impossible, to replace an expensive item improperly depreciated to a point where the policyholder is financially unable to purchase a replacement item.

To determine depreciation, Colorado follows the broad evidence rule which requires that allrelevant factors must be considered to determine appropriate depreciation. This requires looking beyond just wear and tear or market value, and includes looking at all facts and circumstances which would lead to a correct estimate of the value of the particular item.1 These facts may include the original cost, the cost of replacement, collectability, location, use, and even the opinion of witnesses. More important, depreciation should not be taken generally, and items should be depreciated on an individual basis.

Colorado policyholders should always carefully review and scrutinize personal property contents estimates provided by the insurance company to determine whether excessive or unsupported deductions have been made for depreciation. If you suspect the insurance company has not considered all relevant factors to determine appropriate depreciation, consider requesting the insurance company provide a reasonable explanation of the depreciation methodology used in determining the depreciation applied to the individual items.
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1 Nebraska Drillers, Inc. v. Westchester Fire Ins. Co., 123 F.Supp. 678 (D.Colo.1954).