Businesses and individuals are always looking for ways to minimize their tax burdens. One way to do this is through cost segregation.
Cost segregation is a strategic tax planning tool that allows businesses and individuals who have purchased, constructed, remodeled, or expanded property to reclassify some of the costs associated with the property.
These reclassifications include real property (39-year life) or rental property (27.5 years) to personal property or land improvements (5, 7, or 15-year life).
This reclassification results in a shorter depreciation schedule and accelerated tax deductions, which ultimately lowers the amount of taxes owed. This can be a significant advantage, especially for businesses that are in a high tax bracket, giving them more cash flow and improving their bottom line.
Ultimately, a dollar saved today is worth more than a dollar saved tomorrow, so taking advantage of every opportunity to minimize taxes is important.
If you’ve recently purchased, constructed, remodeled, or expanded property, cost segregation could be a great way to save on taxes. Keep reading to learn more about cost segregation and what to expect if you decide to go through with it.
What Is Cost Segregation?
First, depreciation is an important concept to understand. Depreciation is an income tax deduction that allows businesses to recover the loss in the value of the tangible assets used in income-generating activities. The IRS sets depreciation schedules for different types of property, and the schedule depends on the type of property and its expected life span.
For example, the standard depreciation schedule for commercial real estate is 39 years. This means that the cost of the property is spread out over 39 years for tax purposes while that of residential rental property is spread over 27.5 years.
Now, cost segregation is the process of identifying and classifying personal property and land improvements that are a part of a commercial or residential property. These items are then segregated from the real property, so they can be depreciated over a shorter life span than the standard 39 years.
This results in accelerated depreciation and lower taxes because the deductions are taken over a shorter period of time.
Cost Segregation Study
A cost segregation study looks at each asset of property, interior, and exterior, to determine which assets can be classified as personal property or land improvements. The study also looks at the costs associated with each item to come up with an accurate depreciation schedule.
Cost segregation studies are typically done by certified public accountants (CPAs) or engineers who specialize in this area.
They will dissect a property’s construction cost or purchase price and allocate the costs to different asset classes. These asset classes have different tax lives, which means they are depreciated over different time periods for tax purposes.
The most common way to classify assets is by their function. For example, a cost segregation study might break down the following categories:
- Land Improvements
- Building Structure
- Interior Fixtures and Equipment (FF&E)
- Exterior Improvements
- Personal Property
A cost segregation study aims to minimize your taxable income in the early years of ownership by depreciating the assets over a shorter timeline. This can result in substantial tax savings, particularly if the property was purchased or constructed recently.
It’s important to note that cost segregation studies are not about evading taxes – they are simply taking advantage of the IRS tax code to maximize your deductions. In fact, the IRS has even issued guidelines on cost segregation studies.
What To Expect
A cost segregation study is worth considering if you own commercial property. But what should you expect?
Here’s a brief overview:
The first step is to have your CPA or engineer analyze your property. They will look at factors like the original purchase price, construction costs, and blueprints to identify which assets can be classified as personal property or land improvements.
Once the study is complete, you will receive a report outlining the different asset classes and their associated tax lives. This report will be used to file your taxes going forward.
But not all property can be depreciated using cost segregation.
In order for an asset to be classified as personal property or land improvements, it must meet the following criteria:
- It must be a property you own.*
- It must be used in your business or income-producing activity.
- It must have a determinable useful life.
- It must be expected to last more than 1 year.
If your property meets all of the above criteria, then cost segregation could be a great way to minimize your taxable income.
Good Candidates for a Cost Segregation study
Essentially, all taxpayers that own or lease property used in their trade or business may benefit from a cost segregation study.
Properties that are good candidates for a cost segregation study are those that were constructed, placed in service, or acquired within the past 15 years. A cost segregation study can also be performed on properties that underwent a significant renovation, expansion, or conversion within the past 15 years.
Properties with a depreciable cost basis of around $1 million or more, or a leasehold improvement of around $300,000 or more, will often see the biggest benefit from cost segregation.
Studies have shown that properties that undergo a cost segregation study can increase their first-year deductions by 10-20%. But in some cases, the benefits can be even greater due to 100% bonus depreciation, thanks to TCJA.
Some examples of property types that may benefit from a cost segregation study include:
- Commercial office buildings
- Retail stores
- Industrial warehouses
- Apartment complexes
- Hotels and Restaurants
- Mixed-use properties
- Self-storage facilities
- Auto dealerships
- Medical offices and clinics
- Manufacturing plants
- Retail and convenience stores
When Should You Consider Doing A CS Study?
There are a few key things to remember when considering whether to do a cost segregation study…
First, it’s important to note that the most benefits of cost segregation are best realized in the first year after the property is placed in service – constructed, purchased, or remodeled.
That’s because the larger the pool of assets to be depreciated, the greater the potential tax savings.
Second, you should consider the costs of the study itself. A cost segregation study can range from a few thousand dollars for a small property to tens of thousands of dollars for a large commercial property.
So while there is potential for significant tax savings, you need to ensure the study’s cost doesn’t outweigh the benefits.
Finally, you should keep in mind that a cost segregation study can be a complex and time-consuming process. It’s important to work with a qualified CPA or engineer who has experience performing these types of studies.
Doing a cost segregation study can greatly minimize your taxable income and maximize your deductions. But it’s important to make sure it’s the right decision for your situation.
Look-Back Studies
If you invested in depreciable buildings or improvements in previous years, you may be able to go back and “look back” to reclassify those assets and take advantage of the benefits of cost segregation.
Thanks to the Tax Reform Act of 1986, you can retroactively claim missed depreciation, as long as the property is not fully depreciated. Generally speaking, you should look at the amount of basis left in the property to depreciate and the remaining life based on the placed in service date.
This is a great opportunity for taxpayers to go back and review their property for potential cost segregation opportunities.
The process for look-back segregation studies is similar to regular cost segregation studies. The main difference is that the study will focus on identifying assets placed in service in previous years.
Like regular cost segregation studies, look-back segregation studies can be complex and time-consuming. So it’s important to work with a qualified CPA or engineer who has experience performing these types of studies.
The Bottom Line
Cost segregation is a great way to minimize taxable income and maximize deductions. But it’s important to make sure it’s the right decision for your situation.
It’s also a great way to add revenue to your firm by offering to do cost segregation studies for your clients.
If you’re thinking about doing a cost segregation study, be sure to work with a qualified partner, like Tri-Merit. We have ample experience performing cost segregations for individual clients and partnering with firms to serve their clients.
We’ll help you understand the potential benefits and drawbacks—specific to your situation.
Ready to find out more? Get in touch with the professionals at Tri-Merit today.