If you haven’t considered a cost segregation study on your property, there is good probability that you haven’t claimed the appropriate amount of depreciation, meaning that you could have missed out on tax deductions in the form of additional depreciation expenses earlier in the life of the property.
A cost segregation study is defined as the process of identifying and separating out personal property (IRC §1245 property) that is or has been grouped with real property (IRC §1250 property). A cost segregation study determines the appropriate asset class life for the entire tax basis of the property.
This is important because without the study, the asset class-life for a commercial building is 39 years. Certain components of the building and building systems can qualify for shorter class lives. The assets identified to be shorter class lives will be depreciated over 5, 7, 10 or 15 years. For many commercial buildings, these assets might be special electrical, lighting, water, plumbing, mechanical, and finish components. It is not uncommon to identify 25-50 percent of the building’s total costs to be eligible for reclassification into shorter life assets. According to the U.S. Treasury department, “Cost Segregation Studies are a lucrative tax strategy that should be considered in almost every real estate purchase.” An average study for a $1million purchase or new construction could generate over $250,000 of accelerated depreciation over the standard 39 years.
Commercial real estate depreciation benefits will generally be maximized as a result of a detailed, engineering-approach cost segregation study. As the depreciation deductions increase, your current tax liability decreases; thereby improving your cash flow and increasing after-tax profits.
Contractors and real estate investors who own their offices, warehouses or other facilities have an increased interest in conducting cost segregation studies. These studies may help in offsetting current ordinary income with depreciation deductions, at ordinary income tax rates. However, to sell the underlying asset, one might generate a capital gain or depreciation recapture at the 25 percent rate. Both the capital gains tax rate and the 25 percent depreciation recapture rate are likely lower than the ordinary rate for which the owner received the depreciation deduction. Companies can also benefit from the time-value of money, getting a tax deduction now, as opposed to future tax years.
While cost segregation studies can be particularly helpful in improving cash flow on new construction, they can also provide tax and cash flow benefits for existing structures. In fact, virtually every taxpayer that owns, constructs, renovates or acquires a commercial real estate structure should consider these benefits.
The use of cost segregation studies began increasing in the late 1990’s following several prominent tax court cases and related IRS rulings. Interest intensified further in 2013 and 2014, when the IRS issued new tangible property regulations governing the capitalization and depreciation of certain capital expenditures. These regulations also introduced the definition for a unit of property. A building structure consists of the building and its structural components.
Building systems include HVAC systems, plumbing systems, electrical systems, escalators, elevators, fire protection, alarm and security systems, gas distribution systems, etc. It is important to understand the unit of property in order to determine whether an expenditure is required to be capitalized, or if it may be deducted currently.
To determine if an expenditure is to be capitalized, building owners must first understand the unit of property and the building systems. The expenditure is evaluated to determine if it meets the definition of a restoration, adaptation to new or different use, betterment or improvement of the building system and unit of property. A cost segregation will help to identify the specific costs related to these various building components so that building owners can apply the proper tax treatment.
Cost segregation studies became even more valuable with the recent Tax Cuts and Jobs Act (TCJA) changes to depreciation rules. The TCJA increased bonus depreciation for qualifying assets to 100 percent. This means all assets properly classified as an asset class of 20 years or less can be automatically expensed as bonus depreciation under the MACRS depreciation.
In addition, Section 179 was expanded to include certain components of the building. Improvements to a property, such as new roofs, HVAC, fire protection, alarm systems, and security systems will qualify for Section 179. A cost segregation study identifies all the building’s systems to ensure the tangible property regulations were properly implemented.
It is worth evaluating a cost segregation study on property of any size. Commercial property owners may even consider the benefits of a study on a building improvement or addition with a cost basis as low as $250,000.
It is never too late to perform a cost segregation study. If you missed taking advantage of these benefits in the year the property was initially purchased or constructed, or placed in service, you can still do a look-back study if the building was acquired or renovated after 12/31/86. With a look-back study you will claim all of the prior years’ missed depreciation deduction in one year. Amending your tax returns is unnecessary.
Building owners can claim these benefits on a Form 3115 - Change in Accounting Method through an IRC §481(a) adjustment (the difference between the depreciation expense you claimed vs. the depreciation expense you should have claimed). Engineering-based cost segregation studies have been upheld in tax court. The change in accounting method is an automatic change under the IRS regulations and therefore, does not require the IRS’s approval prior to implementing the change.
Contractors can help streamline the process by coordinating the study with the CPA/Engineering team by providing the detailed construction cost data that is needed, organized in a way to facilitate the teams complete study accurately and timely.
The bottom line is that cost segregation studies provide fantastic tax benefits to those owning real estate. It’s typically best to perform a cost segregation study in conjunction with the tangible property rules.
Teri Samples is a partner and director of real estate and construction services with Mueller Prost. She can be reached at [email protected].