Cost Segregation is the practice of identifying assets and their costs and classifying those assets for federal tax purposes. In a Cost Segregation Study, certain commercial building costs previously classified with a 39-year depreciable life, can instead be classified as personal property or land improvements, with a 5, 7, or 15-year rate of depreciation using accelerated methods. Residential buildings, including multi-family buildings are subject to a 27.5 year life. An “engineering-based” study allows a building owner to depreciate a new or existing structure in the shortest amount of time permissible under current tax laws.
The benefits of a Cost Segregation Study include:
- An immediate increase in cash flow
- A reduction in current tax liability
- The deferral of taxes
- The ability to reclaim “missed” depreciation deductions from prior years (without having to amend tax returns)
“Engineering-based” cost segregation enables commercial real estate owners to reallocate real property (under Code Sec. 1250) to personal property (under Code Sec. 1245). This results in a substantially shorter depreciable tax life and accelerated depreciation methods.
Mark Vorkapich wrote an article called “The Benefits of Cost-Segregation Studies” and he broke down an example of tax savings this way:
“The best way to illustrate the effects of cost segregation is to compare a property with and without a study. For example, a taxpayer purchases a strip mall for $1.3 million, excluding land and personal property. If no cost-segregation study is performed, the taxpayer enters the cost into the fixed-asset system as 39-year property. After the first five years, the taxpayer has accumulated $154,622 in depreciation expenses. However, consider the same property using cost segregation. After thorough engineering analysis combined with an understanding of what qualifies as short-life property as defined by Internal Revenue Code Section 1245, the strip mall is reclassified into five-year ($260,524), 15-year ($348,590), and 39-year ($718,457) property. After the first five years, the taxpayer has a total of $460,545 in accumulated depreciation expense.
The obvious difference is that the taxpayer has increased the accumulated depreciation expense by $305,000. With a cost-segregation study, the taxpayer has taken the majority of his depreciation up front and realizes that a dollar saved in the first five years is worth more than the same dollar in 16 years. As a result, the taxpayer has a net present value savings of almost $100,000.”
The distinction between what qualifies as short- and long-life property has been shaped and reshaped during the last 20 years by court cases, private letter rulings, and IRS publications. With these ongoing changes, commercial property owners clearly can benefit from a properly documented cost-segregation study.
What property types benefit most from accelerated depreciation with a Cost Segregation Study?
Many of the costs embedded in a new or existing building can be segregated into categories that also allow for more rapid — or accelerated — depreciation. A Cost Segregation Study is a tool used to maximize the tax benefits of owning a commercial property. Many items inside the building – furnishings, fixtures, flooring and the like – can be depreciated more quickly, over five to seven years; and the site improvement components can be depreciated over a 15-year period.
Best suited for:
- Real estate construction valued at over $1 million
- Building acquisitions or improvements
- New buildings under construction
- Existing buildings undergoing renovations or expansions
Best savings potential:
- Office buildings
- Shopping centers
- Restaurants
- Hotels
- Warehouses and distribution centers
- Manufacturing and industrial plants
- Medical facilities
Learn more about accelerated depreciation and Cost Segregation Studies. A cost segregation analysis can be done independently or conducted in parallel with a Property Condition Report and Environmental Site Assessment. The IRS has detailed information on cost segregation techniques, as well.
For investors considering whether to purchase a commercial property and for real estate brokers trying to make a marginal transaction feasible, a Cost Segregation Study may be essential and Criterium-Lalancette & Dudka Engineers is uniquely qualified to perform it.