What is Cost Segregation?
A cost segregation study might be thought of as an interest free loan that front-loads the depreciation expense deduction a property would otherwise receive over 27.5 or 39 years.
Cost segregation studies free up capital by accelerating the depreciation of § 1245 tangible personal property, land improvements, and Qualified Improvement Property (QIP) as well as identifying various expensing opportunities associated with commercial real estate. The accelerated time frame varies from immediate to 5, 7 or 15 years rather than 27.5 or 39 years for the building (§ 1250).
Who can Benefit the Most from Cost Segregation?
You may benefit from a cost segregation study if your building or improvements were placed-in-service since 1987, but most studies are limited to the last 5-7 years. You may benefit if your building or improvements are currently depreciating over 27.5 or 39 years. If you have over $500,000 in capitalized costs, it’s a good idea to begin thinking about cost segregation.
Ideal building types include apartment complexes, auto dealerships, banks, casinos, distribution centers, grocery stores, health care facilities, hotels, manufacturing facilities, nursing homes, office buildings, restaurants, shopping centers, sports facilities, warehouses, and other specialized property types. Typically, the more complex buildings will generate the greatest benefit from a cost segregation study. It’s important to note that the property owner must be a tax-paying entity.
What are the Benefits of Cost Segregation?
There are several benefits associated with cost segregation and its various applications. The primary benefit of course is significantly improved cash flow. This is most often achieved through accelerating depreciation deductions to defer taxes. This tax deferral, cost segregation may also allow for a reduction of estimated quarterly tax payment and, in some cases, property tax savings.
Cost segregation studies free up capital by accelerating the depreciation of § 1245 tangible personal property, land improvements, and Qualified Improvement Property (QIP) as well as identifying various expensing opportunities associated with commercial real estate. The accelerated time frame varies from immediate to 5, 7 or 15 years rather than 27.5 or 39 years for the building (§ 1250).
When prepared correctly, a cost segregation study can also be an excellent asset management tool. With the release of the IRS Tangible Property Regulations, a well-prepared cost segregation study can serve as the basis to provide defensible values for Asset Retirement or Unit of Property determinations.
The total savings generated from a cost segregation study depend on a few factors. The main factors include the date placed in-service, type of building and improvements, and materials used. It’s also important to note that a cost segregation study does not increase depreciation, it accelerates it. It really comes down to something called the time value of money. The time value of money is a core principle of finance, and it’s the idea that a sum of money is worth more today than it will be in the future. Using cost segregation to accelerate your depreciation deductions and receive a boost to your cash flow now will benefit you in the end.
It is not uncommon for a cost segregation study to generate hundreds of thousands or even millions of dollars in net present value savings. The average study will allocate, (or reallocate in the case of a look-back study), anywhere from 20 – 40 % of the depreciable cost basis to a shorter life. For every $100,000 moved from 39-year to 5-year, the present value savings is approximately $28,000 (based on a 40% tax rate and a 6% discount rate). The 40-year present value savings is approximately $20,000.
When Should a Cost Segregation Study be Performed?
There are several situations where a cost segregation study should be performed. A cost segregation study should be performed immediately after construction or acquisition or following major capital improvements (including leasehold improvements). The study can also be performed after a change in ownership, including a property inheritance or a sale or other transfer of a partnership interest. And finally, a cost segregation study can be useful for buildings already in service. In this situation, a Look-back study would be performed.
The IRS permits taxpayers to use a cost segregation study to adjust depreciation on properties placed in service as far back as January 1, 1987. Many property owners and tax advisors share a common misconception that once the three-year statute to amend has expired, the taxpayer can no longer make a change. Fortunately, this is not the case. Upon completion of the study, the taxpayer is allowed to make an adjustment under IRC §481(a) to catch up on depreciation even from closed tax years. The catch up, which is taken in a single year, is equal to the difference between what was depreciated and what could have been depreciated if a cost segregation study was performed on day one.
These benefits can be quite substantial. As an added bonus, the change can be made without filing an amended return. The taxpayer simply files Form 3115, Application for Change in Accounting Method.
Will Cost Segregation put me at Risk of an IRS Audit?
No. in the event of an IRS audit, the general feeling throughout the cost segregation industry is that the IRS has been getting a bit more aggressive about the review of cost segregations studies with respect to the methodologies being used and the qualifications of the preparer. Per the IRS Audit Techniques Guide, studies being performed by unqualified individuals and those using an abbreviated methodology will receive higher scrutiny than the ones performed by qualified professional who utilized the detailed engineering-based approach. Therefore, it is more important than ever to have your studies performed by an expert in the field.
