By Frederick E. Davis, Jr., JD, CPA, Partner and Michael Coates, Tax Senior, Mitchell & Titus LLP
What is a cost segregation study?
A cost segregation study is the process of identifying the component parts of real property and depreciating components identified as either personal property or land improvements over a shorter depreciation period for federal tax purposes.
With respect to commercial property, certain costs thought to be classified as subject to a 39-year depreciable life, can instead be classified as personal property or land improvements, with a 5, 7, or 15-year rate of depreciation using accelerated methods.
A cost segregation study accelerates depreciation, by classifying Internal Revenue Code (IRC) Section 1250 property costs to IRC Section 1245 property.
That is, classifying components of a building as personal property rather than as a structural building component helps taxpayers to utilize optimum cash flow benefits associated with the acceleration of depreciation.
Federal tax law provides that the basis of a depreciable asset is deducted over the applicable recovery perod assigned to that asset. For a building that is classified as a nonresidential real property, the applicable recovery period is 39 years.
For residential real property, the recovery perod is 27.5 years. Shorter recovery periods can apply to tangible personal property assets that are contained in or attached to the building, and to non-structural land improvements that are associated with the building.
Treasury Regulation Section (Regulation) 1.48-1(e) defines the term “structural components” as such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings therefor such as paneling or tiling; windlows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs;electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes, and other components relating to the operation or maintenance of a building.
However, an item that would otherwise be a structural component will be considered person property under Regulation 1.48-2, if the sole justification for its installation is to meet temperatiure or humidity requirements which are essential for the operation of other machinery or the processing of materials or foodstuffs.
Personal property usually consists of any tangible property that is contained in or attached to a building, provided it is not considered to be a structural component of the building.
Cost Segregation — Advantages
The IRS cost segregation audit technical guide (the “guide”) is provided to IRS audit examiners for guidance to “assist in the review and examination of cost segregation studies.”
While the guide is not an official IRS pronouncement, the IRS notes that “in recent years, increasing numbers of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies”.
A cost segregation study can provide purchasers with significant tax benefits such as accelerated depreciation resulting in an immediate increase in cash flow due to a reduction in current tax liability.
However, before conducting a study, a taxpayer must assess its current and future tax situation to determine whether it would be advantageous to one’s current tax position to accelerate depreciation.
Cost Segregation — Depreciation
Is the term “Cost Segregation” more than a fancy word for depreciation? Absolutely.
A cost segregation study can be highly complex and could relate to accounting, tax law, construction, and engineering.
Cost segregation professionals are able to identify costs that can not be readily computed, such as the mechanical, electrical and plumbing needed to run equipment that is not for the general use of the building.
These professionals are also able to utilize cost estimating techniques to reclassify costs from building to personal property. A building, termed “section 1250 property”, is generally 39-year property eligible for straight-line depreciation and equipment or furniture termed “section 1245 property”, is personal property.
Personal property has a short recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance as oppose to straight line depreciation).
When lump sums costs are available, cost estimating techniques may be required to “segregate” or “allocate” costs to individual components of property (e.g, land, land improvements, buildings, equipment, furniture and fixtures, etc.)
In Shainberg v Commissioner, 33 T.C. 241 (1959), the tax court recognized the right of taxpayers to calculate depreciation using a component method for newly constructed property.
When reclassifying Section 1250 property costs to Section 1245 property, a cost segregation study may segregate or reclassify a portion or percentage of a building’s components (electrical, plumbing, mechanical, etc.) to Section 1245 property.
For example, if the power from an electrical line generally feeds directly to a main electrical panel and actual equipment or machinery to which the overall electrical system provides power, perhaps a percentage of the cost of the electrical panel can be treated as Section 1245 property.
For example, if the electrical panel feeds process equipment (such as manufacturing machinery), then a portion of the cost should be classified as Section 1245 proporty.
The remainder of the cost would remain claissifed as Section 1250 property as it likely relates to building equipment (such as lighting, HVAC and outlets for general accessibility).
Cost segregation studies are valuble to owners of commercial and residiential real estate.
There has been a significant increase in the use of cost studies by real estate purchasers and owners due to associated tax benefits.
As it has become common place for taxpayers to assess the benefits of employing a cost segregation study in order to achieve the tax benefits others have been able to achieve.