If your business currently or historically acquires, constructs, or substantially improves buildings, it may be pertinent for you to consider engaging in a cost segregation study.
By combining accounting and engineering techniques, these studies identify building costs related to tangible personal property rather than real property. You may be able to accelerate depreciation deductions, which in turn could help reduce taxes and boost cash flow. And now, under the Tax Cuts and Jobs Act (TCJA), enhancements to certain depreciation-related breaks allow for even more significant potential benefits.
Learning the Basics
IRS rules generally require depreciation over 39 years (27.5 years for residential properties) for buildings. Personal property, like machinery, equipment, furniture, and fixtures, is eligible for shorter recovery periods over a span of five or seven years. Land improvements, including outdoor lighting, fences, and parking lots, are depreciated over 15 years.
More often than not, businesses overlook crucial opportunities to allocate costs to shorter-lived personal property or land improvements when they allocate all or most of a building’s acquisition or construction costs to real property. In some cases, like computers or furniture, making the distinction between whether an item is real property or personal property is simple. However, in some instances, the line may be less clear.
Certain items may actually be personal property even though they appear to be part of a building. Items like removable wall and floor coverings, awnings and canopies, removable partitions, signs, window treatments, and decorative lighting are all considered personal property.
In addition, certain items that serve more of a business function than a structural purpose, and would typically be treated as real property, may qualify as personal property. These items include reinforced flooring to support heavy manufacturing equipment, electrical, or plumbing installations that are required to operate specialized equipment. Also included in this category are the dedicated cooling systems within data processing rooms.
The relative costs and benefits of a cost segregation study will depend on your unique situation and circumstance, the investment would still be just as valuable. As an example, assume you acquire a nonresidential commercial building for $6 million on January 1. If the entire purchase price is allocated to 39-year real property, you would be entitled to claim $147,660 (2.461% of $6 million) in depreciation deductions during the first year. A cost segregation study may uncover the ability for you to allocate $1 million in costs to five-year property that is eligible for accelerated depreciation. By reallocating the purchase price, you can increase your first-year depreciation deductions to $323,050 ($5 million × 2.461%, plus $1 million × 20%).
When it comes to making partial asset disposition elections, as well as deducting removal costs under the recently issued final tangible property regulations, a cost segregation study may offer some worthy assistance. Consulting with your CRI tax advisor about the possible interaction may prove beneficial if your situation allows.
The TCJA Impact
Tax breaks enacted with the passage of the TCJA also enhance the benefits of engaging in a cost segregation study. Along with other items, this passage now permanently increases limits on Section 179 expensing. Under the limit of specified thresholds, Section 179 allows you to immediately deduct the entire cost of fixed assets or qualifying equipment. It also temporarily increased first-year bonus depreciation to 100% from the previous 50%.
Understanding the Benefits of Look-Back Studies
By conducting a “look-back” cost segregation study, you can claim missed deductions as far back as 1987. Filing Form 3115, “Application for Change in Accounting Method,” with the IRS gives you the chance to claim a one-time “catch-up” deduction on your return for the current tax year without the need to amend any previous years’ returns.
Considering Property and Sales Tax
Cost segregation studies also support the treatment of property tax or sales tax for certain items. For instance, you could use a study to document tax-exempt property costs. Many states even exempt property used in manufacturing.
It’s important to remember that specific property may be treated differently for property tax and income tax purposes, and you run of the risk of double taxation should reporting mistakes occur. Assume your state has a personal property tax, and you choose to use a cost segregation study to reclassify certain building components as personal property for income tax purposes. If you report these items to the state as taxable personal property, but your state law treats them as part of the real estate for real property tax purposes, the same items may be taxed twice – both as real property and as personal property.
To avoid this double taxation, be sure to maintain systems that track the costs of these items separately for both property tax and income tax purposes.
Is a Cost Segregation Study Right for You?
Although these studies typically produce considerable benefits, they aren’t necessarily right for every business. To determine whether or not a cost segregation study is right for your business, contact your CRI tax advisor for an initial evaluation to assess the potential tax savings.