Cost Segregation: The Right Asset Classification Produces Huge Tax Savings

February 6, 2020 | Article

Taxpayers who spent at least $500,000 to purchase, build or renovate a building in the last 15 years may be sitting on a huge tax benefit. How do they find out? They do a cost segregation study.

What is a cost segregation study?
A cost segregation study helps taxpayers accelerate depreciation deductions, which reduces taxes paid resulting in increased cash flow. This cash savings is achieved by cost segregation professionals examining the components classified as part of the building through an IRS approved process.

After the components are examined, some are reclassified into the proper and most beneficial asset depreciable life category. For example, an asset that is incorrectly classified as part of the building structure to be depreciated over 39 years is moved to a non-structural component that can be depreciated over 15 years.

While the total amount of depreciation available on the asset does not change, shortening the life results in the total depreciation available being taken over a shorter period of time, which produces current tax savings. But to realize that current tax savings, the owner of the building undergoing a cost segregation study should be paying current taxes.

When done correctly, cost segregation studies accelerate your depreciation deductions resulting in a lower tax bill and an increase in current cash flow.

How is a cost segregation study done?
A quality study should result in all of the building components being broken down and assigned to appropriate depreciable recovery periods.

As an example, let’s take a look at a grocery store. Recovery periods would include:

  • 5-Year: Examples of items potentially classified as a 5-year assets include vinyl flooring; the electrical cost directly related to operating coolers, refrigeration equipment, and display lighting; plumbing cost connected to the coolers and refrigeration equipment; signage; shelving; and other equipment.
  • 15-Year: Examples include the parking lot pavement, landscaping, and sidewalks.
  • 39-Year: Examples include structural components such as the roof, concrete floors, HVAC to heat and cool the grocery store, and walls.

The process completed in performing a cost segregation study includes:

  • A site visit to determine if the building plans are accurate, identify those items that can be moved into the 5-year and 15-year “buckets,” and document the property through pictures and narrative video in case the study is ever looked at by a third-party.
  • Construction specialists then use the building plans to determine measurements, electrical power loads, and other counts of the building components and classify them according to the recovery periods referenced above.
  • The building components that are segregated above are then priced using “an accepted third-party pricing source” that is consistently applied to all of the building components.
  • A thorough report is prepared that explains the process and, more importantly, the tax justification for those items moved to a 5-year or 15-year recovery period.

A quality study will use specialty engineering software that can download the building plans, perform all of the engineering calculations, and determine the appropriate pricing for the calculations by linking with a third-party pricing service. This methodology results in greater accuracy and more importantly, a document that supports engineering and pricing processes in one location.

Who benefits from a cost segregation study?
The most important factor in determining if a cost segregation study makes sense is probably the easiest question to answer. If you are paying significant taxes and are in a higher bracket, the benefit of a cost segregation study is easier to determine. If you are in a low bracket and have most of your income sheltered through other depreciation or other deductions, then the benefit of a cost segregation study is not nearly as significant. This is probably the most important question in determining if it even makes sense to complete the initial analysis.

What does success look like when it comes to cost segregation studies?

There are a variety of types of businesses that could benefit and see dramatic results from a cost segregation study. Here are just a few examples.

Business Purchase

  • A business recently purchased a $7.1 million business park. As a result of a cost segregation study, the owner was able to generate almost $250,000 in tax savings in the first year. And, almost $500,000 in tax savings are estimated to occur in the first five years.
  • Another business owner had a similar result with an early 2018 purchase of several new buildings valued at just over $16 million. The completed cost segregation study, combined with the newly enacted 100 percent bonus depreciation provision, resulted in tax savings of $1.1 million.

Business Construction

  • When a business recently built a $15 million manufacturing facility, a cost segregation study, coupled with 100 percent bonus depreciation on qualified property, gave the owner a first-year tax deduction of $3 million.

Business Renovation

  • Renovating a building can also produce benefits when components of the renovation are properly classified for depreciation purposes. The $5 million developer investment in the renovation yielded a $2 million first year tax deduction after a cost segregation study was conducted.

Cost Segregation as a Tax-Saving Opportunity

If you own real estate, cost segregation could be a very beneficial tax planning tool. IRS rules allow taxpayers to apply a cost segregation study any time after the building is purchased, renovated, or constructed, which provides a unique opportunity to plan which tax year depreciation deductions are realized. 

 

Don’t leave money on the table.
Cost segregation can help you increase cash flow and reduce tax liability.

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