At its core, cost segregation is a fairly simple tax-deferral concept — you save on current taxes by reclassifying Internal Revenue Code Sec. 1250, real property, to Sec. 1245, personal property. From a tax perspective, this reclassification can generate huge tax and cash flow savings. Real property is depreciated over 39 years for non-residential property or 27.5 years for residential property. Personal property depreciation is decades shorter. Depending on the type of personal property, the tax recovery periods range from five, seven or 15 years.
Additionally, real property uses the straight-line depreciation method, but personal property allows for the use of accelerated depreciation methods, which further increases current tax savings. It’s easy to see how making this switch from Sec. 1250 to Sec. 1245 property could result in significant tax and cash flow benefits. In fact, cost segregation is one of the most effective tax-deferral tactics available to property owners.
The bottom line depreciation deductions are the same, with or without the use of cost segregation. However, the benefit of accelerating depreciation is significant because it puts the tax savings in the property owner’s pocket much more quickly. Given the time value of money and the immediate benefits of tax savings during a tough economy, the cost-segregation concept is worth considering or reconsidering for a wide range of property owners.
Cost segregation is not a new concept. Property owners have been using this strategy or its predecessors for decades. Still, many property owners are reluctant to make the change. Some believe their property is not large enough to benefit and others cling to straight-line real property depreciation because their building is old and that method has been used for years. However, cost segregation is an effective strategy for both smaller properties as well as older ones. Failure to consider a cost analysis could result in unnecessarily prepaying your tax liability.
While the cost-segregation concept is simple, implementation can be somewhat complex but not unduly costly. However, the expense is generally recouped quickly. To properly document your cost allocation, property owners must have a thorough cost segregation study prepared by experts who are well versed in the intricacies of reclassifying property. Documenting the process and the results are critical to the success of the cost segregating analysis. A cost segregation report should be a collaborative effort between a CPA and a consultant with an engineering/construction background. The engineer understands the construction allocation of the project and the CPA understands the tax classifications of the allocations.
A report provides specific details about a wide variety of the building components and classifies them according to the IRS guidelines for either real or personal property. For example, electrical systems, plumbing, wall coverings or other specialized building equipment may be reclassified from real property to personal property. A specialized, detailed report is required because not all plumbing or all electrical systems, for example, will qualify for this reclassification. The qualifying components of a property must be analyzed through onsite investigation, studies of construction documentation and blue prints and other relevant analysis, so guessing is not an option. Then the tax law must be applied to ensure the engineers’ reclassifications withstand an IRS review.
Studies can be performed at the time of acquisition or construction or they can be prepared after the fact (sometimes known as a look-back study). Look-back studies are beneficial if favorable depreciation was previously overlooked and tax depreciation has been understated. Look-back studies allow taxpayers to look back, adjust depreciable lives and take a cumulative catch up depreciation deduction for their current year tax return. If the catch up depreciation deduction is large enough, a net operating loss is generated that can be carried back, generating a tax refund. Amended returns are not required.
Projects with a cost as low as $500,000 can benefit from a cost-segregation analysis. Obviously, the larger the project, the greater the tax benefit. While the immediate tax benefit varies greatly, depending on the building type and structure, many cost segregation studies can result in annual savings of as much as $50,000 per $1 million in acquisition costs.
What Are the Tradeoffs?
Of course every tax strategy comes with at least a few tradeoffs and cost segregation is no exception — although the pros far outweigh the cons. Here is a quick list of some of the issues to consider before switching to a cost-segregation strategy:
- Like-Kind (Section 1031) exchanges: This tax-deferral tool for property replacement can be used in conjunction with a cost-segregation strategy to maximize tax deferrals. However, the relationship between the two strategies should be weighed carefully because of depreciation recapture concerns for the personal property component if the property becomes part of a future like-kind exchange. While recapture needs to be weighed, a cost-segregation strategy should not be simply ruled out because a property is a future like-kind candidate.
- IRS scrutiny: While some property owners worry that a cost-segregation strategy will result in undue scrutiny by the IRS, this worry is generally unfounded. It does not appear that the IRS targets these strategies and it is documented that a correctly conducted cost-segregation study is acceptable as justification for your depreciation decisions.
- Local jurisdiction tax considerations: Depending on your local tax entities, city, county or state, real property and personal property may be treated differently for property tax calculations. While this will most likely not negate the significant benefits of cost segregation, it is an avenue to explore before implementing such a strategy.
Despite some mostly minor disadvantages, a cost-segregation strategy offers the potential for significant current tax savings for property owners of all sizes. The concept is worth a close exploration and careful analysis. The process can help conserve cash. It may even generate a tax refund!
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Brian Williamson, CPA is a tax partner in Real Estate Services Group for Weaver, the largest independent regional accounting firm in the Southwest. www.weaverllp.com