A cost segregation study is any real estate owner’s best friend. If you own buildings or are thinking about constructing a building to rent or use in your business, what could be better than a non-cash deduction to offset current-year taxable income? A cost segregation study helps accomplish this by accelerating the depreciation on the property and therefore increasing the deductions that can be taken in the earlier years.
Essentially, a cost segregation study shifts building costs from 39-year (commercial) or 27.5-year (residential) real property to 5, 7 or 15-year personal property (Section 1245) and Qualified Improvement Property (QIP). The depreciation deduction for properties with shorter asset life is front-loaded at the beginning of the depreciation period instead of being spread out through the longer life of the building.
For example, a taxpayer purchases a commercial building for $3 million (excluding the land). The building contains a kitchen with appliances, cabinets and other components that amount to $200,000. Such items can be “segregated” from the building, which means the personal property of $200,000 can be depreciated over a much shorter period than the remainder of the building costs that will be depreciated over 39 years. This same philosophy can be followed with the entire structure of the building: electric, HVAC, roof, etc.
In this example, once the building is broken down into its component parts, the 39-year depreciation life before segregation will usually average down to approximately 18 years depreciation life. Converted into dollars, a 39-year life on $3 million is approximately $77,000 ($3 million divided by 39) per year in depreciation, whereas an estimated 18-year life after cost segregation would convert to approximately $167,000 ($3 million divided by 18) per year in depreciation. Assuming a combined, effective tax rate for federal and state purposes of 40 percent, this would equate to approximately $36,000 in annual tax savings.
This basically equates to an interest-free loan on future tax liability. Provisions such as bonus depreciation (Section 168(k)) and Section 179 depreciation make this an even more attractive proposition, as taxpayers can write off up to 100 percent of the cost of personal property and QIP in the initial year the building is placed in service. (The 100 percent bonus depreciation provision is scheduled to start phasing out in 2023, so now is the time to consider the study to keep more tax dollars in your pocket instead of Uncle Sam’s.
Ideally, a taxpayer would perform the study in the year the building is placed in service, allowing them to maximize the “time value of money” effect. But a taxpayer can also choose to take advantage of the benefit years later by taking the cumulative effect of the accumulated depreciation to date in the year the study is done. Typically, a study done within the first five years of the building being placed in service would yield the most benefits.
Like any business strategy, there are pros and cons to consider. In addition to its many benefits, there are costs associated with hiring certified architects and engineers to perform the study and prepare the report, which provides the breakdown between real property vs. personal property and QIP costs.
A taxpayer would likely need to perform a cost-benefit analysis to determine if the study would make sense for them. The cost is typically very insignificant to the potential savings, and in many cases these experts will perform this cost-benefit analysis free of charge. The cost of the study would also be deductible, which could soften the blow.
And if the property is sold, the tax gain on the sale would be higher because the additional depreciation would have reduced the adjusted basis in the building, thereby increasing the gain to be recognized.
Even with these considerations, we can probably all agree a deduction today is more valuable than potentially paying tax in the future. Paying less taxes now allows any business owner to make greater investment into their business today to better finance their operations and improve their bottom line.
For more information, contact Ronald Eagar at Grassi Advisors & Accountants at firstname.lastname@example.org.