Commercial real estate owners have a number of options when it comes to tax savings, but few have as direct an impact on the bottom line as cost segregation. This tax planning strategy is one of the most effective methods to implement accelerated depreciation of your property, increasing deductions and deferring taxes. It can also play a large part in boosting cash flow. Cost segregation works by decreasing the 39-year depreciation period that applies to most commercial real estate — it reallocates the property’s assets into categories of personal property that have five, seven or 12-year depreciation periods. This decreases the taxes owed by allowing for increased depreciation-related deductions.
While cost segregation is a familiar concept to most commercial real estate owners, many are at a loss as to exactly how the process works and why it would be beneficial to take that step.
The Cost Segregation Study Process
The first step in cost segregation is the cost segregation study. This consists of a thorough evaluation of the building that examines every aspect of the property, including purchase costs, blueprints, improvements and the terms of lease agreements. Although much of the analysis may seem to be accounting based, these on-site inspections must be carried out by a qualified cost segregation specialist with an engineering background to ensure proper appraisal of the property.
Cost segregation professionals start by conducting a physical inspection of the building and the details of its construction to determine which elements are structural and which ones may qualify as “tangible personal property” according to the IRS. This includes interior components such as carpet, non-essential and decorative lighting, wall coverings and equipment as well as exterior elements such as landscaping and even sidewalks.
What’s more, new rules for tangible assets have allowed commercial property owners to take advantage of tax benefits that were traditionally available only when disposing of property. For example, before the rule changes, owners were prohibited from taking a loss when they completely replaced an element such as the roof and instead had to continue with the original depreciation schedule of the old component in addition to capitalizing and depreciating the new one. Now, commercial real estate owners can write off the remaining value of the old element as a disposition loss and then depreciate the new one as normal, resulting in more tax benefits. At the end of the study, the engineer evaluates the function of these non-structural components to determine their depreciation periods and provides a write-up of his findings.
The best time to do a cost segregation study is when you first acquire a property so you can begin realizing the tax savings sooner. Some new purchases may even provide an additional depreciation deduction of 30 to 50 percent within the first year of ownership. However, even if you've owned a property for a year or more, you can still recoup past depreciation by utilizing the IRS "catch-up" provision. This mechanism allows you to recover overlooked depreciation from as far back as 1987, resulting in immediate tax savings the year you file.
Cost Segregation Study Requirements
Cost segregation studies are only available for properties with owners who pay federal taxes. In addition, the building must have been placed in service on or after January 1, 1987. There are no restrictions on how the savings can be applied, so new construction, new purchases, past purchases, renovations and tenant-requested improvements are all eligible.
Beyond the legal requirements, it’s also a good idea to look at the practicality of conducting a study. Request a study estimate, and run a cost/benefit analysis to determine if the possible savings will outweigh the cost. In general, taking on the expense of a cost segregation study makes the most sense for properties that are valued at $1 million or more. This threshold drops to $300,000 for cost segregation that’s related to leasehold improvements or tenant-requested customizations, as these situations usually lead directly to increased revenue.
While the actual savings you can realize from cost segregation vary depending on your specific circumstances, commercial real estate owners can often count on thousands, or even millions, of dollars’ worth of tax savings and increased cash flow. Experts have found that cost segregation can move 20 to 40 percent of a building’s assets from the real property category to the personal property category. This means that, on average, every $100,000 worth of assets that go from a 39-year depreciation schedule to a five-year timeline with a 40 percent tax rate will net about $28,000 in savings over 10 years.
Cost segregation is one of the most powerful tools in a commercial property owner’s arsenal when it comes to bolstering tax savings and increasing cash flow. Also, increasingly advantageous legislation regarding the depreciation and categorization of property has created an encouraging atmosphere for commercial real estate professionals to implement this tax strategy. Successful execution, however, requires specialized knowledge of cost segregation studies as well as generally accepted accounting principles and tax laws, so it’s imperative to obtain expert opinions before fully committing to this tax optimization approach.
For more information about how a cost segregation study can benefit your business or other tax savings strategies, contact the tax professionals at Goldin Peiser & Peiser.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.