Depreciation is a reduction in the value of an asset over time resulting from wear and tear, deterioration or obsolescence. The tax law acknowledges depreciation by allowing taxpayers to take deductions over a period of years. The number of years over which the property can be depreciated depends on the category into which it falls under the Modified Accelerated Cost Recovery System (MACRS), which applies to business assets acquired after 1987.
The law also permits certain assets to be further broken down into their components. For instance, the category “landscaping” can be defined as “bushes, shrubs and retaining walls.” Categorizing assets in this way allows each element under landscaping to have a different depreciation period. Valuing assets this way also can result in tax savings because assets have greater value in the first few years after they are acquired.
Cost Segregation Studies
This is the essence of cost segregation studies. They identify and reclassify personal property assets that are grouped with real property assets to shorten their depreciation time for tax purposes.
The main benefit of conducting a cost segregation study is that the business may be able to reduce its tax liability and taxable income, which can mean increased cash flow. There are a number of other advantages as well:
- Assets can be depreciated over a shorter time, resulting in lower tax payments. This, in turn, can free up cash that can be used to meet the business’s other needs.
- Cost segregation studies can establish the depreciable tax value of certain building components that are likely to be replaced in the future.
- They can also identify opportunities for other tax credits and deductions.
- It may be possible to recapture unrecognized depreciation for older properties in the year the cost segregation is completed.
- Cost segregation study documentation creates an audit trail that can 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 the following:
- The 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.
- The rules for bonus depreciation have changed. 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 may be eligible for both changes.
Despite these benefits, cost segregation studies aren’t appropriate for every business. There are downsides, including the cost of the study (especially for businesses that aren’t currently profitable), the possibility of triggering depreciation recapture (i.e., the amount of 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 quite severe).
If you think you may benefit from a cost segregation study, the prudent thing to do is to minimize your risk by hiring a team that is familiar with how these studies are conducted and reported. Contact us to get started today.