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 costs previously classified as subject to 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. 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.
Why a Specialist is Needed
For both new and existing properties, the IRS requires that engineering-based cost segregation studies be performed in order to realize the maximum depreciation benefits. Engineering-based cost segregation studies provide more precisely segregated property information, giving CPAs the information and detailed supporting documentation they need to meet with strict IRS regulations and requirements for audit defense.
In the IRS Cost Segregation Audit Techniques Guide (ATG), Chapter 4, the prime attribute of a high-quality cost segregation study is “preparation by an individual with expertise and experience.” The Audit Techniques Guide adds: “Preparation of cost segregation studies requires knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. Experience in cost estimating and allocation, as well as knowledge of the applicable tax law, are other important criteria.
What Types of Items are Identified?
Through an engineering-based cost segregation study, a wide range of building components, such as electrical installations, plumbing, mechanical components, and finishes can be identified and reclassified into shorter-lived asset classes. This adds up to substantial savings to the client.
What Role Does “Time Value of Money” (TVM) Play?
Cost segregation is based on the fundamental principle that “a dollar today is worth more than a dollar tomorrow”. The same logic applies to the statement: “a tax deduction today is worth more than a tax deduction tomorrow”. By accelerating a buildings’ depreciation, property owners can lower their tax liability and thus realize a significant increase in cash flow. This larger cash flow—resulting from postponing tax payments—is available for other investments.
The IRS’s Audit Techniques Guide (ATG)
In late 2004, the IRS released the guidelines their agents must follow for audits of cost segregation studies. This guide reviews the methodologies recognized by the IRS for asset allocation. It examines the various characteristics of a quality study. Referring to the “detailed engineering approach,” the guidelines state: “In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation.”
The Bottom Line
Cost segregation studies are one of the most valuable tax strategies available to owners of commercial real estate today. This increasingly popular phenomenon, offers facility owners the opportunity to defer taxes, reduce their overall current tax burden, and free up capital by improving their current cash flow. Virtually every taxpayer who owns, constructs, renovates, or acquires a commercial real estate structure stands to benefit from a cost segregation study.
Contact us for more information on First Beacon’s Cost Segregation services.