Developers, buyers and owners of commercial real estate often overlook cost segregation studies because of the perception that they simply result in a timing difference in how a building is depreciated. However, cost segregation can lead to significant tax deferrals, a boost in cash flow and an increase in capital immediately available for new projects—and the new tax law has made it even more valuable for a limited time.
The new tax reform act introduced a permanent tax saving opportunity for the 2017 tax year. Lower 2018 tax rates means that deductions applied at higher rates are more valuable in 2017 than in the 2018 lower rate structure. This enables taxpayers who placed into service a new building or a purchased real property in 2017 to maximize their depreciation deductions in 2017 and realize a permanent saving on their 2017 tax returns. Any new or purchased properties placed into service in prior years for which a cost segregation study has yet to be performed could also qualify for the opportunity.
In addition, changes to the bonus depreciation rule mean taxpayers who buy an existing building will now be able to expense all personal property that was normally depreciated over five years. In the past, bonus depreciation was applicable only to new qualified property.
What’s Involved in a Cost Segregation Analysis?
A cost segregation analysis is an engineering-based study of all the costs associated with the construction or purchase of a commercial real estate property or a residential rental property.
The objective of the analysis is to allocate the costs resulting from the construction of a new real estate property or from the purchase of an existing one to either real property or personal property. In general, a real estate property includes elements of personal property that can be depreciated more rapidly than the elements of the property that relate instead to the structure and various systems required to operate or maintain a building.
Cost segregation can benefit any business or individual who owns commercial real estate or certain types of residential real estate. A cost segregation analysis can be conducted on any type of commercial real estate property, including retail and shopping plazas, offices, manufacturing plants, mixed-use, warehouses, restaurants, banks, dealerships, hotels and more, as well as residential rentals such as apartment buildings.
How Are Assets Reclassified Through Cost Segregation?
Instead of depreciating an entire real estate property over 39 years (for commercial property) or 27.5 years (for a residential rental) with a straight-line method, personal property assets identified during the course of cost segregation analysis are assigned shorter cost-recovery periods of five or seven years and can be depreciated using accelerated methods. Costs inherent to certain land improvements can be assigned to a 15-year recovery period.
Therefore, a cost segregation analysis leads to faster depreciation write-offs that can translate into significant tax benefits for a taxpayer who owns commercial (or certain types of residential) real estate.
How Much Tax Savings Are Possible With Cost Segregation?
The tax benefits of a properly administered cost segregation analysis will vary greatly depending on the type of property.
In general, for every $1 million reallocated from a 39-year property to a 5-year property, the net present value over the life of the property is approximately $200,000. The increase in cash flow associated with the reallocation of $1 million is approximately $330,000 over the first five years of placing the property into service.
Are There Other Benefits of Cost Segregation?
Cost segregation is also a valuable tool that can be used in future partial disposition of an asset, a concept that can yield significant tax savings yet is still relatively new to most taxpayers.
Regulations issued by the IRS in 2014 regarding the treatment of costs related to the repair and improvement of tangible property increased the value of cost segregation analysis as a tax planning tool. These regulations provide that a taxpayer can elect the partial disposition of an asset and write-off the remaining adjusted-basis of the disposed asset.
These regulations also define eight different systems in a building, in addition to the building structural components, that each constitute a unit of property (UOP):
- HVAC system
- Electrical system
- Plumbing system
- Gas distribution system
- Fire protection and alarm
- Security system
A UOP is now the reference point for capitalization and disposition decisions. Because a cost segregation study enables taxpayers to allocate costs between the different UOPs of a building, it can be the foundation needed to make decisions regarding capitalization and partial disposition of assets with consideration for repairs or improvement to elements within a building’s UOPs.
Where to Start?
Increased cash flow, tax savings and basis for future partial disposition are substantial benefits that should not be overlooked by developers, real estate investors, and owners of commercial property and residential rental property.
Taxpayers should start by checking if a cost segregation study was ever performed on their existing real estate portfolio. The best time for a cost segregation analysis is in the months following the property being placed into service, but look-back studies can be performed and can yield significant benefits, depending on the facts and circumstances.
The second step is to discuss cost segregation with a tax advisor. Cost segregation involves principles of both tax and engineering and is usually performed by firms who have expertise in both fields. A qualified tax professional with an engineering background can conduct a cost segregation engineering study to reclassify the assets in order to accelerate depreciation, defer tax and increase cash flow.