Cost Segregation Studies

What Is Cost Segregation

Commercial buildings are subject to a 39 year depreciation schedule for tax purposes (27.5 years for apartment buildings).  Real property assets often consist not only of  land and buildings but also land improvements and tangible personal property, each subject to a different depreciation schedule.  An  Engineering-Based Cost Segregation Study is an IRS approved method to separate out the land value, identify the various depreciable components of a  property and then  reclassify them in accordance with  shorter depreciation schedules of either 5, 7, or 15 years.

Who Should Have a Cost Segregation Study

Purchasers of real property can gain significant  tax benefits by using cost segregation.  Cost segregation can  be used when constructing a new building, buying an existing one, or in certain circumstances years after disposing of one, so long as the year of disposition still is open under the statute of limitations (see revenue procedure 2004-11).   According to the Journal of Accountancy “CPAs should routinely recommend that their clients or employers use cost segregation studies whenever the expenditures for a structure, including leasehold improvements, equal or exceed $750,00".

What Are the Benefits

Cost Segregation does not change the total depreciable amount of the building cost, rather it accelerates a portion of the total depreciation into shorter time periods. This partial acceleration results in a substantial benefit for the owner as the result of the  “Time Value of Money”,  which means that a dollar today is worth more than a dollar tomorrow.  Capturing eligible tax deductions sooner rather than waiting 39 (or 27.5) years provides the owner with a cash-flow benefit that would not be possible without conducting the Cost Segregation study.

Example of Present Value Savings
Each $100,000 in assets reclassified from a 39-year recovery period to a five-year recovery period results in approximately $16,000 in  net-present-value savings,  assuming a 5% discount rate and a 35% marginal tax rate.  (Source: BKD LLP)

Why Is it Ok to Do this

Hospital Corporation of America [HCA] v. Commissioner, 109 TC 21 (1997), is the seminal cost segregation case. In it the Tax Court permitted HCA to use cost segregation with respect to a multitude of improvements . Critical to the Tax Court’s analysis was that in formulating accelerated depreciation methods, Congress intended to distinguish between components that constitute IRC section 1250 class property (real property) and property items that constitute section 1245 class property (tangible personal property). This distinction opened the doors to cost segregation.

How Does it Work

The assets comprising the property are separated-  into four categories:

Personal property can usually be depreciated using a 5 or 7 year recovery period (using the double-declining balance method).
Land improvementscan usually be depreciated using a 15 year recovery period and is subject to  accelerated depreciation (150% declining-balance method).
Buildingsare further broken down into component parts and 5 or 7 year recovery periods. 
LandNot subject to deprecation.

Who can do a cost segregation study

The IRS requires an engineering-based Cost Segregation Study.  Most CPA and appraisal firms lack the necessary engineering expertise in house and therefore,  either do not do them or  prefer to out source the work.  You need a specialist.   A  Cost Segregation specialist will have the engineering, construction and valuation knowledge and experience such that they can provide the necessary detailed supporting documentation to meet IRS requirements.  According to the IRS Cost Segregation Audit Techniques Guide (ATG), Chapter 4, the prime attribute of a high-quality cost segregation study is “preparation by an individual with expertise and experience.”

Why Choose Our Firm

We bring our engineering, construction and valuation knowledge and understanding of the relevant portions of the tax code to the job.  We work with your accountant to develop a depreciation strategy that fits your needs.