Cost segregation is a tax planning strategy that involves the segregation and proper recovery period classification of a building’s components. By completing a cost segregation analysis, taxpayers can take advantage of accelerated depreciation deductions and reduce their overall tax liability.
What are the Basics of Cost Segregation?
Cost segregation is based on the concept that the components of a building have varying depreciable lives. When a building is put into use, it is typically depreciated over a period of 39 years (or 27.5 years for residential properties). As a result, you can claim annual depreciation deductions during the building’s depreciable lifespan.
Cost segregation allows you to front-load your depreciation deductions by segregating the various building components for accelerated depreciation (typically five years, seven years, and fifteen years). These components are often related to the operation and maintenance of the business rather than the building itself. The outcome is a potentially significant depreciation deduction that can offset a current year's tax liability.
Bonus depreciation rates will factor in the amount of tax savings for the first year the building was placed into service. Tax year 2022 was the last year for 100% bonus depreciation. It has officially dropped to 80% for 2023 and will drop an additional 20% each tax year through 2026.
In order to properly segregate the building components, it is important to work with a qualified engineer or professional who can accurately identify the various components of your property.
How is a Cost Segregation Study Conducted?
A quality study can result in all of the building components being broken down and assigned to appropriate depreciable recovery periods.
As an example, when looking at a typical office building, recovery periods could potentially include:
- 5-Year: Carpeting, electrical components directly related to computers, communication systems, and decorative lighting, decorative casework, removable wall coverings, brand signage and other office equipment.
- 15-Year: Parking lot pavement, landscaping, fencing and a storm sewer system.
- 39-Year: Structural components such as the roof, exterior walls, HVAC to heat and cool the office and general plumbing.
Eide Bailly’s cost segregation approach includes various elements to ensure you’re receiving the maximum benefit. Our process includes:
- An initial proposal assessment to consider the possible tax benefits. This is a free proposal that will lay out your overall scope, benefits and fees.
- A kickoff call is performed between our fixed asset services team members and your team to confirm everyone is on the same page and ensure efficiency in gathering the necessary documentation.
- The site is visited to determine if the building plans are accurate and to identify the various assets that can be moved into the five-year, seven year, and fifteen-year “buckets.” Pending the scope of the analysis, additional documentation is obtained related to any energy efficiency property that may qualify for additional deductions or tax credits. The property is also thoroughly documented in case the study is ever examined by a third-party.
- An Eide Bailly construction engineer will use the building plans or on-site documentation to determine measurements, electrical power loads, and other counts of the building components and classify them according to the recovery periods referenced above.
- The segregated building components are then valued using an accepted third-party source that is consistently applied to all the building components.
- A thorough report is prepared explaining the process and, more importantly, the tax analysis for those items moved to a five-year, seven-year or fifteen-year recovery period.
- The final step is implementation into your depreciation software. Our fixed asset services team has experience in a wide range of software and systems to ensure your results are properly realized.
Who Benefits from a Cost Segregation Study?
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.
With that said, deductions are not necessarily the only benefit of completing a study. Componentizing the building assets can aid with future repair expenses and partial dispositions.
Beware limitations
Note there can be limitations on a taxpayer’s ability to claim losses, including the passive activity rules, the at risk rules, the basis limitation rules and the overall business loss rules.
What Does Success Look Like When It Comes to Cost Segregation Studies?
There are a variety of businesses that can materially benefit from a cost segregation study. Examples include:
Business Purchase
A business recently purchased a $6 million business park in 2022. As a result of a cost segregation study, the owner was able to generate almost $555,000 in tax savings in the first year utilizing 100% bonus depreciation.
Business Construction
When a business recently built a $15 million manufacturing facility, a cost segregation study, coupled with 100% bonus depreciation on qualified property, gave the owner a first-year tax deduction of $4.75 million.
Business Renovation with Partial Disposition
A dental practice renovated their existing space for $1.5 million in 2022. It was determined that $725,000 fell into the Qualified Improvement Property (QIP) bucket which is depreciated over fifteen years with 100% bonus depreciation, and $200,000 was determined to be five-year property.
QIP describes any improvement that is Sec.1250 property made by the taxpayer to an interior portion of a nonresidential building placed in service after the date the building was originally placed into service. However, there are various improvements that do not qualify for QIP, which increases the importance of having a qualified individual perform the cost segregation analysis. A partial disposition analysis was also performed on the assets that were disposed of and resulted in an additional $300,000 in deductions. The total analysis yielded approximately $360,000 in year one tax savings.
Cost Segregation as a Tax-Saving Opportunity
If you own real estate, cost segregation can be a 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.