What is a Cost Segregation Study?

A great number of small businesses occupy buildings which they have purchased or built for their operations. While they are depreciating the building on their books using a reasonable estimated useful life, for tax purposes the company is generally required to depreciate the building using a 39 year life (for non-residential property).

A very popular technique for these businesses to reduce their tax liability (and as a result, increase their cash flow) is to utilize a cost segregation study. The objective of a cost segregation study is to increase cash flow from buildings, purchased properties, and renovations by accelerating depreciation expense deductions. The overall amount of depreciation over the life of the building doesn’t change.

Cost segregation is the process of identifying personal property assets that are grouped with real property assets, and separating out personal assets for tax reporting purposes. Personal property assets include a building’s non-structural elements, exterior land improvements, and indirect construction costs. Effectively, based on the results of a cost segregation study, the company can reclassify 10-15% (and often more) of costs that would be depreciated over 39 years as a building as personal property with 5, 7, or 15 year tax lives. And, the company can declare these reclassified assets for all open years, even retroactively.

In order to report the benefits cost segregation on the current or past year tax returns, a cost segregation study is required. When discussing this option with clients, we are often asked why a study is needed. The reason is rooted in the Tax Reform Act of 1986. When the Reagan administration spearheaded this transformation of the tax code, the ability to use component depreciation went away. Instead, companies were forced to use the ACRS or MACRS system to depreciate assets. A seminal Tax Court case (Hospital Corporation of America [HCA] v. Commissioner, 109 TC 21 (1997)) led the way for companies to take advantage of a form of component depreciation once again.

In response to this Tax Court victory, the IRS needed an effective way to ensure that cost segregation was being applied reasonably. The IRS requires that contemporaneous justification of the position taken by the taxpayer exists, and that qualified persons perform the segregation. Thus, a cost segregation study is required.

All sorts of buildings qualify for this treatment. In addition, the properties can be brand new build outs or preexisting structures. Most building or renovation projects can qualify for a cost segregation study, including office buildings, manufacturing facilities, warehouse facilities, apartment buildings, and healthcare facilities. Furthermore, companies that have basis in leasehold improvements can also apply cost segregation to benefit from shorter depreciation lives.

Not everyone can benefit from a cost segregation study. It does no good if a business owner is not paying taxes, or if they are not holding onto the property very long. Generally, if the building owner is currently paying taxes, has a basis of $1 million or more, and plans to hold the building for more than three years, they should speak to their tax advisor and consider a cost segregation study.

Written by:
Steve Arman
TGG Accounting

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