Cost segregation is a tax planning strategy that reduces federal income tax liability by accelerating the depreciation of commercial building costs. It can be a smart way for businesses to make their real estate investments work for them sooner.
Let’s look at the cost segregation process and the benefits of doing a cost segregation study.
What is cost segregation?
Cost segregation is the process of separating (or “segregating”) personal property assets from real property assets in a commercial building.
- Real property assets (called Section 1250 property in the tax code) are the permanent, essential structural components of a building. These components include the exterior walls, doors, windows, floors, stairs and roof. Real property depreciates over a 39 or 27.5 year life.
- Personal property assets (Section 1245 property) include non-structural building components such as fixtures, flooring, finishes and affixed furniture. Personal property assets have shorter useful lives than real property, and depreciate over a 5, 7 or 15 year life.
Some building components, such as the electrical, plumbing and HVAC systems, are tricky to classify. They are related to the operation of the building, which can put them in the slower-to-depreciate real property category. However, the IRS allows building owners to classify certain equipment as personal property if it’s integral to business operations.
A cost segregation study answers these property classification questions. It identifies which assets can be reclassified from Section 1250 real property to Section 1245 personal property, with proof to back up each claim.
The ultimate goal of a cost segregation study is to shorten the building’s depreciation time. This reduces the owner’s income tax liability in the near term.
What types of commercial properties make solid candidates for a cost segregation study?
Types of commercial properties that make solid candidates include:
- Buildings valued above $500,000 (excluding land)
- New construction
- Real property stepped up through estate
- Leasehold improvements
- Purchase of existing property, renovations or expansions
- Existing property placed in service after January 1, 2000
What are the benefits of a cost segregation study?
An engineering-based quality cost segregation study allows owners to write off portions of their building in the shortest amount of time possible and take advantage of the time value of money. Cost segregation accelerates the depreciation timeline. Instead of having to wait 27.5 or even 39 years to see any depreciation-based tax savings, building owners can begin reducing their tax burden early on in their property’s life. This frees up cash for investments, improvements or operations.
The 2017 Tax Cuts and Jobs Act (TCJA) contains favorable depreciation rules that make cost segregation studies even more beneficial. Real estate investors can receive immediate expensing of certain Section 1245 personal property. Bonus depreciation doubled from 50% to 100% on certain qualifying assets. A cost segregation study identifies these assets. Not only does it apply to new construction and renovations, but the TCJA also made it possible to apply cost segregation to purchases or acquisitions.
A cost segregation study may also uncover additional opportunities for reducing real estate tax liabilities.
When is the best time to do a study?
Most consultants will tell you that the best time for a cost segregation study is the year the property is placed in service by the current taxpayer. However, there is a distinct advantage to engaging in a study even before you break ground on a new building. Reviewing blueprints during the planning phase of construction ensures maximum tax savings.
There can also be great value in “look-back” cost segregation studies that allow business owners to catch up on depreciation for properties placed in service in years past. Generally, we don’t recommend going back more than 20 years because, in most cases, the financial gain may not be worth it.
Another important point to remember is that performing a cost segregation study is simply a change of accounting that requires the filing of form 3115, and will not involve amending returns. As the tax season gets into full swing, it’s a great time for CPAs to discuss whether a cost segregation analysis would be in order.
What is the process of doing a cost segregation study?
The preparation of a quality cost segregation study requires experience in three distinct areas:
- Specialty tax law
- Cost estimating and allocation
- The construction process
This puts cost segregation studies out of the everyday purview of most business owners and accountants. Partnering with a specialty tax firm like Tri-Merit that specializes in cost segregation studies is a smart solution. The Tri-Merit cost segregation team includes both engineers and CPAs.
There are no specific IRS regulations dictating how a cost segregation study must be carried out—only the final product. Typically, a construction engineer will analyze the building’s architectural drawings; electrical, lighting, telecommunications, plumbing and HVAC drawings; and other blueprints. A specialist will typically perform at least one site inspection. With that information, the team can then segregate the structural and general building components (Section 1245 personal property) from the Section 1250 real property components.
The result is a comprehensive work paper file and supporting documentation.
According to the IRS, a cost segregation study should do three things:
- Classify assets into property classes
- Explain the rationale (including legal citations) for classifying assets as either Section 1245 or Section 1250 property
- Substantiate the cost basis of each asset and reconcile total allocated costs to total actual costs
I’m interested in a cost segregation study, but I’m concerned about an audit. Does cost segregation increase audit risk?
The IRS does tend to look at cost segregation because it can be abused. However, when done properly by an expert specialty tax partner like Tri-Merit, you can feel confident in your claim.
The preparer’s credentials and level of expertise can have a bearing on the accuracy and quality of a study. This is why so many CPAs and CFOs trust Tri-Merit to deliver a quality cost segregation study that will hold up against the most stringent IRS audit. We also include tax audit defense with every study we perform.
How do I find out if a cost segregation study will benefit my company?
Contact Tri-Merit at (847) 595-0094 for more information or to set up a consultation. There’s no cost or obligation. We can start with a few questions—and answer any of yours—to see if a cost segregation study is a smart investment for your business.