How a cost segregation study can help reduce your company’s tax liability.
Any business that owns real estate could benefit from a cost segregation study, a tax methodology that allows you to accelerate depreciation on your property, which can result in significant tax savings.
Cost segregation is an engineering-based approach to identifying assets within a building that can be reclassified into a much shorter depreciation recovery period than the building itself.
Real estate properties are generally depreciated using a straight-line method of 39 years (27.5 years for residential properties). These properties are defined as real property.
A cost segregation expert can help with identifying, classifying and segregating the personal property components and land improvements of the building, resulting in accelerated depreciable lives of five, seven and 15 years. Nonstructural items such as carpet, accent lighting and specialty wiring can qualify for accelerated lives.
What is Depreciation?
Depreciation is the allowance for the exhaustion, wear and tear, and obsolescence on certain types of property used in a trade or business for the production of income. Property is depreciable if it’s used for business or held for the production of income; has a determinable life exceeding one year; and it wears out, decays, becomes obsolete or loses value from natural causes.
Is cost segregation allowed by the IRS? Yes! Rulings by the IRS, including Hospital Corporation of America v. Commissioner, have confirmed the applicability of cost segregation. The IRS also recognizes cost segregation studies with the use of an engineer or valuation expert on the project.
Who Can Benefit from Cost Segregation?
Most properties that have been constructed, purchased or renovated since 1987 qualify for this tax benefit. This includes manufacturing plants, assisted living facilities, hotels, restaurants, multifamily buildings and many more.
To determine if a cost segregation study is appropriate for you, the following circumstances need to apply:
•Is the cost of your building at least $750,000?
•Have you purchased, constructed or renovated any property since 1987?
•Do you plan on retaining your property for the next few years?
•Do you have net income that is being taxed?
There are certainly “triggers” that you should look for to help identify an opportunity for a cost segregation study. Common events that indicate an opportunity include constructing a new facility, acquiring an existing facility, renovating or expanding, or new tenant improvements.
If you have built or purchased buildings or facilities in the past, and haven’t performed a cost segregation study, you might be able to benefit from a study which allows for correction of missed depreciation in past years.
What are Examples of Potential Savings?
Let’s look at a cost segregation study for a sample office building.
This is a typical two-story office building with a total construction cost of $3 million, assuming that 25 percent of the cost of the building was improperly classified as real property (39 year) instead of personal property (seven year) and land improvements (15 year). By moving the 25 percent that was improperly classified as 39-year property to seven- and 15-year property, the first-year tax savings realized would be approximately $33,000. The total tax savings and After-Tax Net Present Value Benefit (ATNPV) of the entire project is as follows:
•Seven-year property $600,000
•15-year property $150,000
•Total Reclassified: $750,000
•First-Year Tax Savings $33,000
•Cumulative Five-Year Tax Saving $175,000
When looking for a consultant to conduct a cost segregation study, you should ask if they have engineers or construction experts on staff. It’s more than just about tax savings: The cost segregation study process requires a consultant who also understands construction drawings and building layouts to accurately identify the correct depreciation.