Cost segregation is the practice of identifying depreciable assets and their costs, and classifying those assets into the appropriate depreciable life in order to obtain the maximum allowable depreciation under federal tax law. The following three-step process for allocating costs helps taxpayers assign as much cost as possible to the most advantageous depreciable life:
- Make an initial cost allocation between land and building based on their relative fair market values (note that if a cost allocation is agreed to between a buyer and seller and included in the sales contract, the IRS will generally use the agree-upon allocation instead of another cost segregation plan);
- Identify land costs that can be classified as land improvement costs and thus be depreciated over a 15 year recovery period (e.g., sidewalks, roads, paved parking lots, drainage facilities, bridges, fences and landscaping adjacent to buildings); and
- Analyze building costs to identify tangible personal property that can be segregated and depreciated over 5 or 7 year recovery periods.
When trying to determine how to allocate land and building in step 1, absent a qualified appraisal, taxpayers can use any reasonable method provided it is realistic and supportable. The IRS has previously accepted the following methods as reasonable:
- Estimated replacement cost;
- A taxpayer’s own expertise and knowledge; and
- The appraisals of local tax assessors in the absence of better evidence to determine fair market value.
Typically, most of the time and effort in the aforementioned three-step process occurs in step 3 where the building costs are allocated between structural components and tangible personal property. Structural components (e.g., walls, floors, ceilings, central heating and air systems, plumbing, electrical wiring, lighting fixtures, etc.) are depreciated using recovery periods of 39 or 27.5 years whereas movable building costs (e.g., carpeting, partitions, removable floor tiles, seating booths, signs, ornamental structures, etc.) although contained in or attached to a building qualify as tangible personal property that can be depreciated using recovery periods of 5 or 7 years.
Cost segregation studies used to substantiate accelerated depreciation recovery periods normally require the individuals or firms creating them to have expertise and experience in such projects (such as engineers) because the IRS challenges those that are not well-prepared and documented or prepared by unqualified persons. Due to the cost of hiring a cost segregation expert, a cost-benefit situation exists whenever a taxpayer considers if they need a cost segregation study. Typically, cost segregation studies benefit acquisitions and constructions that exceed $1 million (excluding land) and that are held for more than three years; however, other factors also come into play.
Cost segregation can be one of the most valuable tax strategies available to commercial real estate owners by accelerating the depreciation of individual components included in the original cost. Contact Flexible Accounting Services of the Triangle today to see if this strategy could reduce your tax bill by increasing or accelerating your allowable depreciation.