Depreciation is a reduction in the value of an asset over time resulting from wear and tear, deterioration or obsolescence. Tax law acknowledges depreciation by allowing taxpayers to take deductions over a period of years. The number of years over which property can be depreciated depends on the category into which it falls under the Modified Accelerated Cost Recovery System that applies to business assets acquired after 1987.
Most commercial buildings must be depreciated for tax purposes over a period of 39 years. Most personal property, including furniture and equipment is depreciable over shorter periods. New personal property is eligible for additional first-year depreciation, or bonus depreciation, allowing businesses to deduct a large percentage of the purchase price of eligible assets.
Among buildings or building improvements, only certain building improvements are eligible for bonus depreciation or immediate write-offs. If a specific item is classified as personal property rather than part of a building, for example, the depreciation deductions for that item generally are available sooner. In economic terms, it will have a greater present value to the property owner.
This is the essence of cost segregation studies. They identify and reclassify personal property assets grouped with real property assets to shorten their depreciation time for tax purposes.
Just as it’s desirable to properly allocate between improvements and land, it’s equally important to identify and document items that are personal property and items that are structural building components.
For example, a chair is personal property depreciable over five or seven years. A load-bearing wall is a structural component of a building depreciable over 39 years. For such items as electrical systems, floor and wall coverings, heating and cooling systems, lighting fixtures, plumbing and signs, distinctions are governed by tax rules that can be complex, involve projections as to the future use of the items and could even necessitate consultation with engineers or other construction experts.
After personal property and building items are identified, they must be separately valued either by an appraisal, a breakdown of construction costs or both.
A cost segregation study also can look back on property placed in service in years past. Let’s say you constructed a commercial building seven years ago, but didn’t have a cost segregation study performed at that time. Today, a cost segregation look-back study could be performed to catch up on the accelerated depreciation deductions missed over the last seven years.
There’s no need to amend seven years of prior tax returns. This special catch-up deduction can be claimed by filing for a change in accounting method and deducting the full amount in the current tax year.
The main benefit of a cost segregation study is the business could reduce its tax liability and taxable income, which also could mean increased cash flow. There are other advantages as well:
Depreciating assets over a shorter time and lowering tax payments. This can free up cash to meet other needs.
Establishing the depreciable tax value of building components likely to be replaced in the future.
Identifying opportunities for other tax credits and deductions.
Creating a trail that could prove invaluable in the event of an IRS audit.
The Tax Cuts and Jobs Act of 2017 expanded the benefits of cost segregation studies. Among the most notable changes are:
Expansion of property qualifying under IRC Section 179, which allows businesses to deduct the full purchase price of qualifying equipment and software purchased or financed during the tax year. The changes apply to assets placed in service in tax years after 2017.
Different rules for bonus depreciation. A business must claim first-year bonus depreciation deductions for qualified property placed in service during the year unless it elects out by property class.
The same property might be eligible for both changes.
Cost segregation studies aren’t appropriate for every business. The downsides include the cost of the study (especially for businesses that aren’t profitable), the possibility of triggering depreciation recapture (income that must be reported when the sale price of an asset exceeds its tax basis or adjusted cost basis) and understatement penalties for taxpayers that use cost segregation too aggressively (the penalties for “aiding and abetting” can be severe).
Special knowledge and experience is essential, so consult with your tax advisor before your acquire commercial real estate or if you believe you might benefit from a cost segregation study on your existing real estate.