Cost segregation is the Internal Revenue Service’s approved method of reclassifying your commercial building from real property to personal property and, in the process, allowing assets to be depreciated on a 5-, 7- or 15-year schedule, instead of the traditional 27.5- or 39-year depreciation schedule of real property. Imagine how this could affect your business. Current taxable income could be reduced greatly while your cash flow would increase by 5 to 8 percent of your building’s cost.
This can translate to some hefty benefits, such as increased cash flow, reduced tax liability, deferred taxes, and reclaiming missed depreciation deductions from prior years. You can do all of this without amending previous tax returns.
When Cost Segregation Is Required
According to the IRS, cost segregation is required when allocating lump sum costs to specific asset classifications. An engineering study performed by a qualified professional using methodologies and procedures as described in the IRS Cost Segregation Audit Techniques Guide is required. The IRS’s preferred method is an engineering-based approach using site inspection, cost records, and technical documentation.
Because cost segregation evolved from years of litigation and rulings rather than from an IRS code section or succinct ruling, the legal basis underlying cost segregation can be confusing. It is important for you to do your due diligence to see and how your property would qualify. You have to start with professional financial help, and eventually bring an appraiser and valuation expert onto the team.
How Accountants Can Help
Accountants play a central role in the cost segregation process. They can recommend techniques and review and implement the findings of the engineering report, which segregates assets into four categories:
- Personal property
- Land improvements
By segregating these property costs, your cash flow has a wider reach. Tax savings can be realized from accelerated depreciation deductions and potentially easier property write-offs. Use cash segregation when constructing a facility; buying an existing facility; or, in certain circumstances, years after disposing of one, as long as the year of disposition is open under the statute of limitations.
As the purchaser of a building, you achieve faster depreciation deductions, as well as possible and easier subsequent write-offs. If real property is reclassified as 5-, 7- and 15-year personal property, it may qualify for a 30 percent or 50 percent bonus depreciation that applies to new property the first year it’s placed in service. This can be an enormous benefit and the resulting cash flow can provide the capital for numerous other projects.
Keep in mind that cost segregation is applicable not only when you acquire new or existing structures but also when you’ve previously acquired or improved a structure. All you’ll need is the proper engineering report to justify cost segregation.
Which Assets Apply
Assets that qualify for accelerated depreciation through the use of shorter tax life depreciation schedules mean that you maximize annual depreciation, reduce upfront income tax costs, lower cost of capital, and improve shareholder value, while increasing your ability to write off individual assets in the future. A primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life than the building, which is up to 39 years for nonresidential real property.
Cost segregation studies are valuable whether you own, construct, renovate, or acquire the relevant building. A cost segregation study will open the opportunity for you to defer taxes, reduce your overall current tax burden, and free up capital. Contact our financial and tax experts to help you review this process today.