Cost segregation separates buildings into a set of components that may be depreciated over 5, 7 or 15 years rather than the typical 27.5- or 39-year period. By allocating each property-related cost into classes, you can calculate depreciation deductions.
The goal of a cost segregation study is to find any construction-related costs that can be depreciated on a shorter schedule than the building itself. Items identified below are affixed to the land but not related to the overall operation and maintenance of the building itself.
- Parking lots.
- Dumpster enclosures.
- Retaining walls.
- Flooring used in the building.
- Extra wiring and plumbing, especially in a manufacturing facility.
To determine whether cost segregation is a viable strategy, conduct a cost segregation study to examine your assets, identifying and classifying them into different depreciation periods to reduce your current income tax obligations. You want to minimize taxes and free up cash flow for growth and debt reduction, for example.
The study itself should create a clear audit trail of cost and asset allocations. If you have a project that is still in the planning stages of construction, you might want to consider doing a study before you begin to get a handle on your potential tax savings. Tax engineering can be used at the blueprint stage to incorporate building designs that will enhance tax savings.
When you construct, expand or renovate a building, you can derive benefits from a cost segregation study to determine what qualifies for accelerated depreciation. Cost segregation allows firms to separate building components into different asset classes — using accelerated depreciation on shorter-life assets and an extended period for depreciated assets classified as being part of the building. The results are tax savings and improved cash flow.
Cost segregation analysis is based on time and materials, or you may be charged a fixed fee, but it may generate hundreds of thousands of dollars in net present value savings as it allocates or reallocates anywhere from 20% to 40% of the depreciable cost basis.
The preparation of a cost segregation study requires knowledge of the construction process and the tax law involving property classifications for depreciation purposes. The benefits of performing a cost segregation analysis are:
- Accelerated depreciation.
- Increased current tax deductions.
- Deferred income tax.
- Increased cash flow.
- Opportunities such as property tax and future retirement benefits.
The 2017 tax reform package affected bonus depreciation — to immediately deduct a certain percentage of your asset costs the first year they are placed in service, and increased the bonus percentage to 100% through tax year 2022. But plumbing, ventilation and alarm systems may not be depreciated on an accelerated schedule.
Does a cost segregation study increase audit risk?
Cost segregation studies are accepted and expected by the IRS, which has issued guidance on how to report the results of a cost segregation study on your tax return.
A good time to conduct a cost segregation analysis is the year the property is placed in service so you can maximize depreciation deductions from the start. A cost segregation study is most beneficial when there’s going to be a significant tax benefit that outweighs the cost of the study.
The techniques and rules are complex, so be sure to work with Lang Allan & Co.