Deep Dive Into Cost Segregation
Cost segregation, also known as the 179 Deduction, serves as a strategic planning tool for evaluating the real property assets of an entity. It involves identifying a portion of the costs associated with these assets that can be categorized as personal property. Through this process, an owner can reallocate expenses that would generally depreciate over a 39-year period to asset groups that undergo quicker depreciation or, in some cases, are expensed immediately.
To enhance cash flow, an investor can expedite the depreciation of recently acquired or renovated commercial, industrial, or rental real estate investments through the implementation of a cost segregation study.
What Is Depreciation & Its Impact On Cost Segregation
Depreciation is an accounting method used to allocate a tangible asset’s cost over its useful life. It reflects the asset’s gradual deterioration, wear, and tear, or obsolescence. Depreciation allows businesses to spread the cost of an asset over several years, matching the expense with the revenue generated by the asset.
The impact of depreciation on cost segregation lies in the ability to identify specific property components that can be depreciated more rapidly. For example, items like carpets, lighting fixtures, and specific building components may have shorter recovery periods than the overall building structure. Cost segregation allows these components to be depreciated over a shorter timeframe, leading to higher tax deductions and potential tax savings for property owners in the short term.
Cost Segregation Calculations
According to IRS regulations, a commercial rental property can undergo depreciation over either 27.5 or 39 years. However, a cost segregation analysis has the ability to divide the property into its individual components, allowing for accelerated depreciation. For instance, interior fixtures and finishes may be depreciated over five years, while land improvements could follow a 15-year depreciation schedule. While the details of the cost segregation process may be intricate, the crucial point to remember is that it enables real estate owners to expedite depreciation, ultimately reducing their overall tax liability. It is essential to note that this process is best handled by an expert, with the involvement of a CPA or tax professional, to ensure accurate completion.
History of Cost Segregation
- 1959: Shainberg vs. Commissioner: The courts ruled (and the IRS later concurred) that Cost Segregation was allowed for tax depreciation on buildings.
• 1973: Revenue Ruling 73-410: This Cost Segregation ruling established that a taxpayer can individually depreciate pieces of used property if a certified appraiser “properly allocates the costs between non-depreciable land and depreciable building components as of the date of purchase.”
• 1975: Whiteco Industries, Inc. vs. Commissioner: The Tax Court created six questions based on judicial precedent to determine whether a specific object qualifies as tangible personal property.
• 1986: Investment Tax Credit (ITC): The ITC is eliminated, and the new MACRS recovery periods for building depreciation are significantly enhanced for property placed in operation after 1986. Commercial property increased to 31 and ½ years, then to 39 years in 1993.
• 1997-1999: Hospital Corporation of America vs. Commissioner (HCA): The most recent landmark decision establishing legal validity for using Cost Segregation Studies to calculate depreciation.
• 1999: In Action on Decision (AOD): The IRS agreed to the application of ITC principles in the HCA case. Later that year, the IRS Chief Counsel released additional guidance (CCA 19992145) that supported the use of Cost Segregation Studies.
• 2004: IRS Issues Audit Techniques Guide: Outlines the criteria for a quality Cost Segregation Study and directs IRS field agents when examining a report that does not use the methodology recommended in the Audit Techniques Guide.
The Tax Cuts and Jobs Act
In 2015, prior to the enactment of The Tax Cuts and Jobs Act, the Protecting Americans from Tax Hikes (PATH) legislation was passed. This law eliminated three property classifications: qualified leasehold improvement property, restaurant property, and retail improvement property. With the introduction of the Tax Cuts and Jobs Act, qualified improvement property was added, replacing the three classifications mentioned above. This new category encompassed the same types of 15-year assets and certain non-structural improvement assets.
This law’s passage made it more advantageous due to including “bonus depreciation” and the immediate expensing of personal property within the first year. This applied to building improvements such as plumbing, ventilation, and alarm systems, now treated as 15-year assets. This development was particularly beneficial for renovators as they could depreciate these assets over a shorter 15-year period. Bonus depreciation enables individuals and businesses to deduct a specified percentage of asset costs in the first year of service.
Benefits Of a Cost Segregation Study
- Increase cash flow
- Reduce tax liability
- Deferral of taxes
- Uncover missed deductions
- Defer income tax
The primary advantage of incorporating cost segregation into a tax strategy is that it front-loads depreciation during the initial years of ownership, substantially reducing investor tax liability. This is particularly beneficial for high-income individuals.
Steps Required to Complete Cost Segregation
Whether investors choose to buy or hold properties, perform renovations, or do new construction, owners, and developers who retain ownership can benefit from immediate tax savings, sometimes amounting to millions of dollars.
When to do a cost segregation study? At the point of purchase or during the early stages of construction.
What is involved in a cost segregation analysis? For income tax depreciation purposes, there are two major types of assets — sec 1250 (real property) and sec 1245 (personal property). By taking advantage of certain rules in the tax law, property may be further segregated within these two sections by identifying five-year or seven-year personal property, 15-year land improvements, and 27.5-year residential and 39- year non-residential real property.
For every $100,000 of cost or value moved from 39-year to 7-year depreciation, the first-year after-tax net present-value benefit is about $17,000 for 2017 and nearly $24,000 for 2018. Since there are quite a few ways to reclassify building components into personal property, performing a cost segregation study is essential. During the planning phase of a construction project, engineers will review the preliminary drawings and make suggestions to improve the tax position.
Building components have a recovery period of 39 years, while personal property, depending on its use, has a recovery period of either five or seven years. This means that being able to classify water lines, waste lines, and process electrical power as personal property rather than building components will decrease their cost recovery period and accelerate depreciation — saving the investor money.
Disclaimer: This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
