According to a cost segregation and tax credit specialist, cost segregation is a strategic tool in saving taxes. Companies and individuals who have built, acquired, developed, or reconstructed any kind of real estate can increase cash flow by expediting depreciation deductions and waiving federal and state income taxes. For the US Treasury Department, cost segregation is a cost effective tax strategy that should be utilized in acquiring commercial real estate.
The concept of cost segregating goes like this. Taxpayers need components and fixtures for their buildings and establishments in order to run their businesses. These items should not be regarded as “structural components” since they are insignificant in operating and maintaining the building. They are, however, classified as “tangible property” or “land improvements.” Under the ruling of the Tax Court, tangible personal properties can be depreciated separately under the Modified Accelerated Cost Recovery System (MACRS) as personal property. In simpler terms, cost segregation will allow you to identify and reclassify personal property from real property. The depreciation time will be shortened and the current income tax obligations will be reduced.
How the Strategy Works
According to the Journal of Accountancy, cost segregation starts at the time of the acquisition of the real estate. It is recommended that an engineering report be used in grouping the assets into four categories: personal property, land improvements, buildings, and land. This will help in attaining faster depreciation deductions.
Personal property can be depreciated via a recovery period spanning from five to seven years and through the double-declining method. Examples of personal property are fixtures, furniture, and window treatments.
Land improvements have fifteen years of usable life. It can be subjected to an expedited depreciation method called 150% declining-balance method. Examples of land improvements are fences and sidewalks.
In the opinion of the Journal of Accountancy, the building’s value must be maximized for any residual value to be apportioned to non-depreciable land. The building’s parts (e.g. roof) can be valued and depreciated separately. If the components were deemed worthless, it can be written off right away.
The amount that was not accounted for in the other three categories is appropriated to the land. Appraising the land in this manner may yield a value that is somewhat low or insignificant.
What is a Cost Segregation Study?
A human capital consulting firm put a Cost Segregation Study (CSS) as an engineering-based analysis that is utilized to expedite depreciation deductions. The main objective is to determine all construction related costs that can be depreciated over five, seven, and fifteen years.
When is a Cost Segregation Study Conducted?
Ideally, it should be performed shortly after the construction or purchase of a building. If there’s a change in ownership, or the buildings are already in service, then a CSS can be carried out. However, proprietors who have no income tax liabilities and who intend to sell their assets in three to five years should not undergo a Cost segregation Study.
Included in the buildings that qualify for a CCS are hotels and resorts, office buildings, restaurants, warehouses, manufacturing facilities, and retail centers.
Who is Authorized to Facilitate a Cost Segregation Study?
A cost segregation and tax credit specialist identified the following as those who can conduct a Cost Segregation Study:
– Engineers, construction firms, and tax experts
– Those who are knowledgeable of the changing tax laws
– Those who have knowledge of previous court cases and rulings related to individual assets
– Those who have complied with the IRS Audit Techniques Guide
– Those who can identify new areas in saving taxes
Benefits and Drawbacks of a Cost Segregation Study
Aside from producing an increase in cash flow by expediting the depreciation deductions, a Cost Segregation Study can reduce income taxes and real estate property taxes and give an independent third-party analysis that will stand up against an IRS audit. However, undergoing an engineering study is quite expensive. Also, the tax code’s recapture provision may be set off. If a Cost Segregation Study is used aggressively, penalties may be imposed upon the taxpayer. But still, the advantages of cost segregation cancel out the disadvantages.