Release Powerful, Underutilized Tax-Saving Strategies for Commercial and Investment Real properties

1. Release Powerful, Underutilized Tax-Saving Strategies for Commercial and Investment Real properties Understanding The Latest IRS Updates Relative to Cost Segregation Studies This document and/or electronic file contains information that (a) is or may be LEGALLY PRIVILEGED, CONFIDENTIAL, PROPRIETARY IN NATURE, OR OTHERWISE PROTECTED BY LAW FROM DISCLOSURE, and (b) is intended only for the use of Best Bottom Lines, LLC. You must have written authorization from Best Bottom Lines, LLC to use, copy or distribute any part of this document as it’s strictly prohibited.

2. Goal of Cost Segregation Studies Goal = to identify all construction-related costs that can be depreciated over 5, 7 and 15 years and reclassified from 39, 31.5 and 27.5 years Traditional depreciation for Real Property is 39 years for commercial property and 27.5 years for residential rental property Personal property is depreciated much quicker and can be depreciated over 5, 7, 10, and 15 years Reducing tax lives results in accelerated depreciation deductions, a reduced tax liability, and increased cash flow “You must pay taxes. But stop leaving a tip.” Would you Rather Get Your Money Back Today or in 39 Years?

3. Major Benefits to The Property Owners? Generates Cash Flow and Minimizes Taxes Look back study for catch-up of depreciation could generate refund Free up money for investments which allows for compounded growth Benefit to clients includes ability to expense versus capitalization of real property when conducting demolition or when remodeling is involved. Reduces real estate property taxes Increase Cash Flow for Maximum Bank Financing Section 179 Benefits Reduced Insurance premiums

4. So What Is The Big Deal? The depreciation for a property with a Cost Segregation Study allows for significant increase in deductions within the first five years. For every $100,000 of cost shifting from 39-year property to 5-year property, the net present value of the tax benefit is approximately $16,000* For $100,000 of cost shifted from 39-year property to 15-year property, the net present value of the tax benefit is approximately$10,600* * Benefits assume a tax rate of 35% and a 5% return on investment

5. Timing Illustration

6. CSS Brief History CS has been around since the 1960’s – it was called Component Depreciation There have been over 200 court cases and IRS rulings supporting the benefits of CS Initial cases were related to Investment Tax Credit (ITC) and whether items related to a structure could qualify for a credit. Congress enacted ACRS 1981 with new shorter lives 40 year life reduced to 15, 18 & 19 years Simultaneously disallowed component depreciation MACRS enacted in 1986 reiterated disallowance of component depreciation

7. Hospital Corporation of AmericaLandmark Decision - 109 TC 21(1997) Court reinstated and expanded a form of component depreciation Certain costs related to specific ordinary use equipment (building support systems that would otherwise be viewed as structural) qualify to be depreciated over life of underlying asset. IRS acquiesced to Tax Court Ruling - 1999

8. CSS Brief History In 1999, the IRS released Legal Memorandum 19921045 in which the IRS agreed not to contest the (HCA) reclassification of building costs into different asset categories that result in shorter depreciation lives This legal memorandum directs agents to verify that an engineering or architectural study has been done to identify portions of the building's system not related to the operation and maintenance of the building Without these detailed studies, IRS agents are advised NOT to accept the reclassifications is a “facts and circumstances” assessment Use of Cost Segregation Study (CSS) must be specifically applied by the taxpayer Allocations based on “logical and objective” measures Not based on non-contemporaneous data, or assumptions without supporting records CSS must be “closely scrutinized” by the field

9. IRS - Audit Technique Guide Issued in April 2004 Developed to assist Field Examiners “WHY” are cost segregation studies performed? “HOW” are they prepared? “WHAT” to review and look for? IRS Cost Segregation Audit Techniques Guide – AssistField Examiners “Why” are CSS performed? “How” they are prepared? “What” to review and look for?

10. What is being said about Cost Segregation? “Property Owners Profit from Change in Tax Law” Audit Technique Guide “Cost Segregation Studies fast growing tax strategy” “Investors find a friend in the IRS” “It is not unusual for engineering consultants to classify 20 to 40 percent of construction as personal property”

11. Qualifying Property Any building placed in service since January 1st, 1987 Existing buildings undergoing renovation, remodeling, restoration, or expansion Major leasehold improvements to any building made after January 1st, 1987 Inheritance of commercial and investment real properties Preconstruction planning to recommend possible modification to the building designs to increase shorter-life asset classification

12. Cost Segregation for an Existing Building“Catch Up” – Look Back If a cost segregation study is conducted on an existing building, The unclaimed depreciation on personal property components that were previously classified as real property can be deducted as a Code Sec. 481 (a) adjustment in the year of change The automatic change of accounting rules of Rev. Proc. 2002-9, apply If a cost segregation study is performed on a building that was placed in service in a tax year that ended before December 30, 2003, The IRS will allow a tax payer to file amended returns to claim the benefits Interest is payable by the IRS on the refund

13. Cost Segregation Studies IncludesNew and Previously Acquired Properties The optimal time to perform a study is the year the property is placed in service Current IRS procedures allow a taxpayer to recover any missed depreciation on properties placed in service as far back as 1987 without having to amend prior years tax returns Cost Segregation is not limited to new construction. In fact, most studies are performed on acquired properties where land and building is purchased for one negotiated price in a previous year NEW CONSTRUCTION Indirect Costs + General Contractor Costs + Direct Costs outside General Contract ACQUIRED PROPERTY Purchase Price Land Cost Building and Site Implementation Cost MACRS - GDS 39 - Year Property 27.5 – Year Property 15 - Year Property 7 - Year Property 5 - Year Property 3 – Year Property OR

14. Benefit of Cost Segregation – Cash Flow – Would You Take the Cash Savings Today? A taxpayer purchases (or constructs) a strip mall for $4 million (land excluded) Without a Cost Segregation Study, the taxpayer would have depreciated $4,000,000 as a 39-year asset over 40 years (straight-line, HY convention) CSS Illustration No. 1

15. Benefit of Cost Segregation – Cash Flow – Would You Take the Cash Savings Today? By segregating assets and applying proper class lives, significant portion of the building can be depreciated faster Typically, about 35% of total cost can be reclassified from real property to personal property for this type of building CSS Illustration No. 1- (continued)

16. Benefit of Cost Segregation – Cash Flow – Would You Take the Cash Savings Today? Cash savings of $320,282 can be achieved over the fist 5 years w/ CSS Although cash savings / tax savings over the tax life of the building does not exist, net present value of the earlier tax savings or deferred taxes due to accelerated depreciation results in net present value of $200,000! CSS Illustration Continued

17. Again, What is the Big Deal? The depreciation for a property with a Cost Segregation Study allows for significant increase in deductions within the first five years. For every $100,000 of cost shifting from 39-year property to 5-year property, the net present value of the tax benefit is approximately $16,000* (NPV = $16.00 per $100 invested) For $100,000 of cost shifted from 39-year property to 15-year property, the net present value of the tax benefit is approximately$10,600* (NPV = $10.60 per $100 invested) * Benefits assume a tax rate of 35% and a 5% return on investment FASTER CASH FLOW!

18. First element of a qualityCost Segregation Study according to the IRS Audit Techniques Guide is: Provider who marries the science of engineering with the principles of tax and accounting to arrive at financial solutions that results in increased cash flow, minimized tax payments and increased ROI. A firm that meticulously follow the IRS guidelines and go beyond the standards and basic requirements outlined by the IRS “Prepared by an individual with expertise and experience.” Select CPAs and engineers familiar with engineering, construction, architectural and estimating processes and techniques are essential for a quality CSS process. Select CPAs and engineers with appropriate tax background and knowledge of over 200 court cases, many revenue ruling and revenue procedures dealing with cost segregation area are essential for a quality CSS. Additional Considerations I think Audit should be first I would also add preconstruction Must understand abandonment issues Knowledgeable on issues involved with §1031 & §1033 exchanges and how they interact with Cost Segregation Must have expertise in Form 3115 Change in Accounting Method filing procedures Understanding how Cost Segregation can affect estate taxes, passive loss situations, IRS §179 deductions, Net Operating Loss situations, §168(k), partnership §754 step-up elections and other tax situations Experience in lease review and identification of “qualified leasehold property” Does the CSS include time for audit support Why are the CPA and Engineer Important in the CSS Process?

19. Tax Planning & Other Benefits Demolition Loss – expense vs capitalize Estate Planning Strategies 1031 Exchange Strategies Real Estate Professional Passive Taxpayer & Multiple Entities • Insurance Premiums • Recapture • Closing Costs (doc stamps) • Property Tax Benefits (RE vs. Tangible PP) • Preconstruction recommendations • Lessor • Lessee

20. 1031 Exchanges Planning With CSS

21. Why do I need an Engineering Expertise for a CSS? Cost segregation study (CSS) is an IRS-sanction technique allowing businesses to accelerate depreciation on their facilities Although the IRS does not prescribe one specific methodology, the IRS’ Cost Segregation Audit Technique Guide does not enumerate several and elevates the Detailed Engineering Approach From Actual Cost Records as “the most methodical and accurate approach” This approach consists of carefully examining all contemporaneous construction and accounting records Estimates or “take-offs” are used to supplement the actual cost detail when the existing detail is not sufficient for the purposes of the study A professional firm comprised of accountants, engineers, and architects with prior cost segregation experience, is required to perform this kind of cost segregation study Methodology without the engineering expertise will not withstand IRS scrutiny in accordance with the IRS Audit Technique Guidelines Without the contractor/engineering expertise coupled with the tax law guidance, there will likely be valuable tax benefits left on the table Determining 1245 property value on existing properties must be properly documented and appraised and indicated according to the IRS Audit Technique Guidelines 3 Words: Mechanical, Electrical, Plumbing

22. Detailed Engineering Approach Identify the specific project/assets that will be analyzed Obtain a complete listing of all project costs and substantiate the total project costs Inspect the facility to determine the nature of the project and its intended use Photograph specific property items for reference. Review “as-built” prints, specifications, contracts, bid documents, contractor invoices and other construction documentation. Identify and assign specific project items to property classes Prepare quantitative take-offs for all materials and payment records to compute actual unit costs Audit Technique Guide “It is the most methodical and accurate approach.”

23. Qualifying Property Property Types Airports Apartment buildings Assisted Living Facilities Automobile dealerships Automotive service centers Banks Casinos Cinemas Day care centers Department stores Distribution centers Fitness centers Funeral homes Gas stations Golf resorts Grocery storesHospitals Hotels Industrial facilities Laboratories Manufacturing facilities Marinas Medical facilities Mixed-use facilities Nursing homes Office buildings Research facilities Retail centers Resorts Restaurants Service stations Shopping centers Sports facilities Storage facilities Warehouses

24. Which Properties Benefit Most? Property Type Percentage Reallocated

25. Cost Segregation Recent Results Project: Apartment Complex – 12 Complexes Cost: $18,100,000 5 Year Tax Savings: $1,585,222 Project: High-End Office Building Cost: $5,234,125 5 Year Tax Savings: $625,678 Project: Hotel Cost: $7,123,456 5 Year Tax Savings: $812,145

26. Look Back Example CSS Look back Example • A taxpayer purchased (or constructed) a strip mall for $4 million (land excluded) in 2000 • Without a Cost Segregation Study, the taxpayer has been depreciating $4,000,000 as a 39-year asset over 40 years (straight-line, HY convention)

27. Look Back Example – continued CSS Look Back Example (continued) IRS Owes The Property Owner $336,604! • What could you do with the new found money of $336,604 that was trapped in the walls of your investment? • Make additional investment • Reduce mortgage debt • Address maintenance items

28. Examples of Pre-Construction Benefits Pre-Construction Planning: In the design phase, CORE can help make the building more tax efficient by identifying business components from the structural components Example: Law Firm uses hinges for $1MM decorative lobby shelving versus attaching shelving with a permanent adhesive Total property is able to be moved from 39-year depreciation to 5-year depreciation for a tremendous savings Example: Hospital installs $1.8MM floating floor system versus permanent attached flooring Structurally as sound, cash savings from more attractive depreciation schedule substantial

29. Insurance Savings Alone May Pay forCost Segregation Study There are a number of benefits to your insurance program after completing a Cost Segregation study: Lower premiums. By providing the insurance underwriter with a Cost Segregation study, they can better understand your risk, their company’s exposure and accurately rate your insurance There is no more guess work on the underwriters behalf and that guess work usually works in their favor in the way of higher premiums to you In the wake of the recent natural disasters affecting the insurance market, most insurance policies are changing from blanket policies to stated value Each location will carry a stated value on the policy and in the event of a claim that is the maximum you can collect A Cost Segregation study will provide you with the piece of mind that you are insured to full value Cost segregation studies allow property owners to accurately insure their business property, leading to a more cost effective use of your insurance dollar

30. Additional Benefits from CSS Demolition/Rehabilitation Ability to identify components of a building prior to demolition and/or rehabilitation which can be reclassified as personal property versus real property Allows the owner to write off these items versus capitalizing the assets which generate a substantial tax savings For example, if a property owner has a $5-million property that they are going to demolish: The total cost would typically get applied to the land with the property owner having no ability to depreciate or recoup the $5-million investment A cost segregation study, prior to the demolition, identifies $1,500,000 of personal property The property owner will now be able to write off the $1,500,000 as abandoned personal property

31. Real Estate Investment Trusts (REITs) Benefit Increase non-cash expense to reduce income and thus minimize dividend distribution, allowing increased cash flow for additional acquisitions REIT dividends have 3 components: Ordinary Dividends Long-Term Capital Gains Dividends Return of Capital Dividends Due to the favorable tax treatment of Return of Capital Dividends (taxed at the long-term capital gains rate of 15% or 25% and tax payment is deferred until the sale of the share), investors typically prefer dividends with the greatest percentage of Return of Capital Cost Segregation increases the Return of Capital component; thereby, increasing the Taxable Equivalent Yield DIVIDEND GROWTH IS INCREASED A significant source of dividend growth is acquisitions REIT must pay out a minimum of 90% of taxable income as dividends, and many REITs pay out over 100% of taxable income.

32. Cost Segregation Asset Class Lives for Restaurants The crux of cost segregation is determining whether an asset is I.R.C. §1245 property (shorter cost recovery period property, 5 or 7 years) – e.g., depreciable personal property, such as equipment – or §1250 property (longer cost recovery period property, 39, 31.5 or 15 years) – e.g., buildings and building components, which generally are not §1245 property The Director for the Retailers, Food, Pharmaceuticals and Healthcare Industry chartered a working group to address the most efficient way to approach cost segregation issues specific to the restaurant industry The group produced a special section related to the required cost segregation study for such purposes

33. Cost Segregation and 1031 Exchanges- Best of Both Worlds - Most valuable tax deferral strategies for real estate are: Cost Segregation (Accelerated depreciation of real estate) 1031 Exchanges (Deferral on the disposition of appreciated property) How To Best Utilize Both Strategies Real Estate Investors and their advisors must understand issues in utilizing both strategies Real vs. Personal Property Real and personal property under section 1031 is determined by state law In contrast, the definition of real and personal property for cost segregation studies is determined under federal law Property such as wall coverings, carpeting, special purpose wiring or other installations affixed to the building can be considered real property under state law and like kind for section 1031 purposes, but be considered personal property in cost segregation studies Real estate owners can benefit from both the gain deferral under section 1031 for real estate exchanges and the enhanced cost recovery deductions of cost segregation study

34. IRS Determination/Tests - Structure or Personal? Permanency test - Sec. 1.48-1 (c) Is the property capable of being moved? Has it been moved? Is the property designed or constructed to remain permanently in place? Are there circumstances which tend to show the expected or intended length of affixation - i.e. may or will be moved? How substantial of a job is removal of the property & how time consuming? Is it readily movable? How much damage will the property sustain upon removal? What is the manner of affixation of the property to the land? Factors that now govern whether property is permanent or can be reclassified in accordance with IRS Audit Technique Guidelines:

35. IRS Determination/Tests - Structure or Personal? The appearance test: Whether the structure looks like a building Generally only requires that the structure enclose a space within its walls and usually be covered by a roof The second part of the test requires that the building function as a building: The courts primarily focused on whether the structure provides working space for employees that is more the merely incidental to the primary function of the structure Both the quantity and qualify of human activity inside the structure may be considered in this regard Appearance and Function Test

36. Items To Be Reclassified in a Cost Segregation Study Site Improvements (landscaping/parking) Light Fixtures Branch wiring Special Plumbing Flooring Millwork Millwork Window Coverings Partition Walls Cabinetry Furnishings Shelving Wall Coverings

37. Qualified Property Property to include: Accordion-style room dividers Decorative lattice millwork used to separate areas These items are not permanent structures therefore do not affect the operation nor maintenance of the building 1245 property Partitions

38. UNIQUE ASSETS TO IDENTIFY

39. Qualified Property Property to include: Main panels Motor control centers Transformers Main distribution panel switchgear Related wiring and conduit The courts conclude that the portion of the cost of the primary and secondary electrical distribution systems which is equal to the percentage of the electrical load carried to those systems allocable to the property equipment, as stipulated constitutes the 1245 qualification class property and is depreciable over an accelerated life Primary and Secondary Electrical Distribution Systems

40. Qualified Property Property to include: Controls Battery packs Battery chargers for emergency power equipment Illuminated emergency and entrance signs Medical gas control and alarm equipment Kitchen equipment Wired clock systems Normally 100% of the load carried relates to this type of equipment, therefore the balance of the electrical is normally allocated to the building Branch Electrical Wiring and Connections, and Special Electrical Equipment

41. Qualified Property Systems supported: Call systems Intercommunication systems Dictation systems Music systems Paging systems Electrical Wiring Relating to Internal Communications • Property to include: • Conduit • Wiring • Electrical connections

42. Qualified Property Property to include: Branch electrical wiring Conduit, floor boxes Junction boxes Outlet receptacles All other equipment in connection with its operation Wiring and Related Property Items Relating to Television Equipment

43. Qualified Property Property to include: Items relating to operation of grease trap systems Trench drains Grease waste piping Waste excavation Waste fill Trap itself All connections (hose and reel connections) Water piping used for operation of kitchen equipment Kitchen Plumbing

44. Qualified Property Property to include: Air intake fans & related duct work Dishwasher condensate return units These items ventilate air, remove humidity and steam, replace air expelled Test: Do the items relate to the buildings operation or maintenance? NO! Therefore are considered Section 1245 property Kitchen Hoods and Exhaust Systems

45. Sample Report – Engineering Calculations Per IRS Guidelines

46. Sample Report – Depreciation AnalysisPer IRS Guidelines

47. Sample Report – Depreciation SchedulePer IRS Guidelines

48. Sample Report – Tax References Per IRS Guidelines

49. The Cost Segregation Study Process Continued… Electrical Site Work Landscaping

50. The Cost Segregation Study Process Prepare final reconciliation Prepare final report Deliver Draft Review with tax advisor Deliver Final Study with sample 3115