Most property owners know a thing or two about depreciation benefits, but very few fully capitalize on them. If you (or your company) have purchased, constructed, renovated, or expanded commercial property since 1987, or made leasehold improvements to it, you’ll want to be aware of a little-known opportunity that can significantly accelerate your tax savings: a cost segregation study.
When a property is purchased, the land, building structure, and the building’s interior and exterior components are included in the purchase price. As a general rule, the cost of land is nondepreciable, and the building cost itself must be written off over 39 years. But it’s those internal and external components, the shorter-lived assets, which constitute a whopping 20-40% of the building on average, that have the ability to be depreciated more rapidly. Cost segregation breaks out certain non-structural components of a building and allocates shorter life classes to those components, depreciating them at an accelerated rate. This means more tax deductions are available in the earlier years, providing the owner an immediate increase in cash flow. In addition, a cost segregation study quantifies a property’s major components and leasehold improvements so they can be written off when replaced or renovated, and provides an independent third-party analysis that will withstand IRS review.
The following are just a few examples of building items which normally qualify for rapid write-off:
- Carpet and furniture, which can be classified as personal property, are depreciable over 7 years.
- Parking lots, landscaping, shrubbery, sidewalks, roads within the property, and outdoor lamps and fencing, which can be classified as land improvements, are depreciable over 15 years.
- Special wiring and plumbing installed to support specific equipment, which can be treated as part of the equipment rather than as part of the building, are depreciable over 5-7 years.
- Vinyl wall coverings and kitchen water piping, depreciable over 5 years.
Under the tax law, building components which are classified as “personal property” and not part of the building can qualify for the additional 50% first year “bonus” depreciation or for immediate deduction under the $500,000 Section 179 expensing election.
What is Involved in a Cost Segregation Study?
A cost segregation study evaluates all information, including available records, inspections and interviews, and presents the findings in a clear, well-documented format. The first step is to enlist the help of a qualified, cost segregation specialist. The IRS has stringent rules in place surrounding cost segregation analyses, and you’ll need an expert in your corner. That specialist will evaluate your property and calculate the projected tax savings. Based on the results, he or she will decide if the benefits from the savings justify moving forward with a cost segregation study.
From there, a property analysis will commence. Your cost segregation specialist will review blueprints, if available, and conduct an on-site inspection to identify components of the property that are subject to accelerated depreciation. The specialist will then prepare the cost segregation study report in the format acceptable to the IRS, which can then be provided to the business owner’s CPA so that it can be incorporated into the current year’s tax return.
When should a Cost Segregation study be conducted?
The optimum time for a cost segregation analysis is at the design and planning phase of a renovation, during construction of a new building, at the time of completion or at time of acquisition, or during real estate tax reviews, as the analysis is based on construction drawings, cost data and comprehensive site inspection. It’s just easier at the beginning since key players like engineers and architects are readily available. That being said, a cost segregation analysis can be performed at any time after the purchase, remodel, or construction of a property built after 1986. In addition, Revenue Procedures 2002-9 and 2002-19 allow you to reclassify costs that previously qualified for shorter lives and “catch-up” those missed deductions immediately (in a single tax year). You will therefore see tremendous benefits in the first year following a cost segregation study.
Are there circumstances where a cost segregation study is a bad idea?
An in-depth cost segregation study can generate substantial tax savings. However, businesses must be certain that spending money on such a study will prove cost-effective. Moreover, if the business plans to sell or exchange the real estate soon, or it is in a current loss position where additional deductions have little value, or is exposed to the alternative minimum tax (AMT), the economic benefit of a cost segregation may not be worthwhile.
Your company’s real estate holdings constitute a huge capital investment, and you have the potential to make those holdings work for you. If you think a cost segregation study makes sense for your building, we can help you get started.