Cost Segregation

Cost segregation can lead to recovered expenses (Birmingham Business Journal)

Mike Baker

A cost segregation study can help a real estate owner recover major capital improvements costs or spur building acquisitions more rapidly - enhancing property returns and cash flow. Essentially, real estate cost segregation is a procedure that significantly accelerates depreciation of investments for construction, acquisition or renovation of business buildings and income-producing residential properties. The procedure generates cash tax savings by identifying shorter-lived assets (personal property) qualifying for five-, seven- or IS-year write-off periods, which typically are costs imbedded in a building's construction or acquisition costs and depreciated during a 39-year period.

Overview

What constitutes personal property and qualifies for an accelerated write-off? An example of items that qualify can be found in any typical office building. Computer cabling installed for a network could be depreciated over five years instead of 39 years. The same would be true for land improvements such as a parking lot, landscaping and fencing, which would qualify for a 15-year write-off period.

In many cases, floor and wall coverings would qualify. Many new facilities have portions of the electrical system that are devoted to running business equipment that also would qualify. For example, a convenience or grocery store has a substantial portion of the electrical system devoted to running coolers and gas pumps that could be depreciated throughout a shorter life.

Qualifying a property

There is no exact test in determining whether an asset is a structural component of the building - and does not qualify - or personal property. Therefore it is up to those who conduct the study to make the proper determination. The judicial decisions, IRS rulings, regulations and other interpretations are complex.

The IRS requires an engineering-based approach to identify the applicable costs to reclassify them into segregated categories. For a new building, a review of contractor and subcontractor invoices and requisitions to reclassify short-lived property generally can satisfy the IRS.

If you answer "yes" to any of the following, then your property may qualify:

. Did you construct or purchase a building after 1986?

. Has the property you own or lease undergone renovations?

. Do you expect to own the property for at least five years?

. Would additional depreciation help you reduce current tax liabilities?

. Is the value of the building at least $750,000, or do you have multiple facilities such as convenience stores, restaurants, etc.?

While the above is an indication that a study could be beneficial, the next step is to run a projection. The present value of the savings is quantified estimating the additional depreciation along with the tax savings and an appropriate discount rate.

Working example

Our firm recently conducted a cost segregation study for the owner of a car dealership facility. The building had been constructed two years ago at a cost of approximately $1.7 million. The study identified $200,000 and $410,000 of property that could be reclassified from a 39-year life to five and 15 years, respectively. As a result, the owner got to take a one-time deduction of $87,000 for all the accelerated depreciation he missed.

Opportunity

While many major corporations and property owners have used cost segregation methods to depreciate their property, there are thousands of smaller property owners who are unfamiliar with the concept and the savings it can produce.

Their advisers often are unfamiliar with it or do not have the expertise to conduct a study. Properly done, a study requires an engineering skill set and expertise that most firms do not have available.

A cost segregation study does not replace the role of the current accountant in determining tax liability or preparing returns. It simply provides the information so that proper depreciation information and savings can be incorporated on the completed return.

Fortunately, it is not too late to avail yourself of the benefits of cost segregation. You do not have to amend prior returns to deduct the depreciation you could have claimed.

Rather, there is an easy mechanism allowing for automatic IRS consent to a change in your method of accounting for depreciation.