When you purchase a building for your business, tax laws allow that investment to be recovered as a deduction over time, usually over a “recovery period.” For a building, this is most often 39 years while land is not considered depreciable. However, by using a cost segregation study to allocate a portion of the building costs to other types of assets with shorter lives, you can accelerate the tax deductions for that investment and pay less tax in the early years rather than delaying those deductions until many years down the road. For closely held business owners, a cost segregation study is one tool that can have an immediate impact on taxable income. One example based on a real-life study is that $1.7 million in new construction costs yielded an increased deduction of $400,000 in the first year.
The crux of a cost segregation study is determining whether an asset is personal property (shorter lived with a recovery period of 5 or 7 years normally) or real property (longer lived typically with a 39 year recovery period, except in the case of land improvements which have a 15 year recovery period). Generally, the determination of whether an asset is personal property rather than real property revolves largely around two factors: (1) whether the asset is constructed to remain in place permanently and (2) the specialized use of the asset in question.
A cost segregation study is a comprehensive analysis of the investment in a newly constructed or existing building. By separating the building costs related to tangible personal property and land improvements, tax deductions are accelerated – thereby increasing cash flow in the earlier years. A cost segregation specialist, working with the general contractor and/or architect, will study blueprints and site plans, analyze cost data and provide a detailed report containing an asset listing with tax depreciation methods and lives.
IRS guidance states that a cost segregation study and report should always classify assets into property classes (e.g. land, land improvements, building, equipment, furniture and fixtures) and should reconcile the costs allocated to the various classes to the total project cost. A quality study is one that is both accurate and well-documented and should be prepared by an individual with knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. (IRS Cost Segregation Audit Techniques Guide – Chapter 4).
Another advantage of a cost segregation study is identifying component parts of a building so they can be written off more easily as they become broken or worn out. For example, if a portion of a building’s cost is allocated to the roof and depreciated separately, there may be an opportunity for the taxpayer to write off the remaining undepreciated cost of that roof when it needs to be replaced with a new one. Without treating this as a separate component, its cost would be intertwined with the building cost and could only be recovered over the full 39 year recovery period.
Many taxpayers are not aware that a cost segregation study can be performed several years after the date of acquisition. An appraisal from the time of purchase can be leveraged to allocate the purchase price based on values at that time. IRS regulations allow a taxpayer to recalculate what the accelerated depreciation would have been in the earlier years and claim that as a “catch-up” adjustment in the current year without amending any prior year tax returns. (IRS Reg. 1.446-1(e)(2)(iii), Example 9.)
When considering the benefits of a cost segregation study, keep a couple of things in mind. First, having a study performed by a qualified professional costs money, a price range that varies based on a number of reasons. Second, since the real benefit of accelerating tax deductions is the time value of money, taxpayers need to consider other potential factors, such as the recapture tax or the tax position of the ownership group, limiting the study’s usefulness. Every taxpayer is unique, so property owners should always consult their Elliott Davis Decosimo tax advisor before engaging a cost segregation professional.