Cost segregation study is the most lucrative tax-saving strategy for all commercial property owners. You can claim faster deductions from the IRS of nearly 75,000 for every 1 million of the building cost. Unfortunately, it is an under-utilized tax benefit because most CPAs do not have in-house expertise in this, even though there are experts who not only do this study for a fraction of your savings, they even work with your CPA and even provide a tax-audit defense.
You may have heard of cost segregation studies as a property owner’s way to tax benefits, but while the overall idea is appealing, the complex process and the prospect of involving the IRS to a greater extent than auto-approving your yearly business tax filing might scare you off and cause you to miss out on the advantage and gains these studies offer.
The benefits of cost segregation studies and their reports consist primarily of accelerated tax deductions for depreciable property, refunds, deferred taxes, and catch-up tax deductions for properties placed in service years ago. In other words, deductions that you normally think you will only be eligible for later might be available much sooner. Aside from their obvious income and property tax advantages, such studies are useful for financial accounting, in general, and also for insurance purposes. It’s preferable that such a study be performed as soon as a property is ready to be placed-in-service so it’s easier to keep accurate records, to find records you may have misplaced, and, of course, to enjoy early deductions.
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What is Cost Segregation Study?
A Cost Segregation Study will identify all property-related costs that can be depreciated over 5, 7, and 15 years, instead of a typical 39-year-old period. Nearly 30% of all interior and exterior components can be written off faster than the core building structure.
Who can qualify for Cost Segregation?
In short, if you are a commercial building owner, there is no harm to get a free preliminary assessment if you can benefit from cost segregation. Owners of commercial buildings, shopping malls, apartments, casinos, gas stations, hotels, warehouses, golf courses, restaurants, manufacturing/factories, IT & biotech companies or people who own at least a few residential houses/units are likely to qualify.
What are the benefits?
A cost segregation study will help in reducing your taxes, increase cash flow, tell you those items which qualify for accelerated depreciation but you have not claimed the benefit so far, “catch-up” tax benefit for older buildings
How much does the Cost Segregation study cost?
If found that you qualify ( or can benefit from) for cost segregation, only then your detailed cost segregation report is prepared by a team of civil engineers, structural & financial evaluators, accountants and other industry experts. They will work with your CPA and even assist if there is a question raised by IRS about a deduction.
The typical cost of a detailed cost segregation report is about $3,000. This report can be anywhere between 100 to 200 pages. Each study has its own fee-based on purchase amount, location, building type, time in service if it’s a 1031 exchange building. In addition, there are studies done strictly on the renovations and if the renovations meet a minimum amount. And the renovations could be owner renovations or Tenant Improvements (TI’s). Fee’s can also be dictated by the type of study being done meaning – is it a one-off, a portfolio of properties. Types of buildings within the portfolio. Any previous client and what deduction they have taken in the past. The average study fee is around $3000 but they can be as high as a few hundred thousand dollars and as low as $1500.
Why has your CPA never spoken about Cost Segregation ever?
Cost segregation is a different ball game altogether. It requires a different set of experts. Cost segregation experts will work with your CPA to ensure that you are fully tax-compliant and the report content is in the comfort zone of your CPA.
Businesses that thrive are the ones who go after every opportunity and advantage they can acquire in order to improve their cash flow and secure their working capital. “Fortune favors the bold”, and in business, you’ve got to explore beyond your comfort zone in order to hunt bigger rewards and add them to your bottom line.
The IRS itself details the benefits of submitting properly executed cost segregation studies, while also warning against non-compliant and inaccurate reporting of assets and their costs. While considering the study you submit for their approval, the IRS can deny the entire study or at least some of its deductions or require more time for further examination, which would delay a determination on the deductions.
The IRS is an institution that does not shy away from applying penalties whenever the rules are not followed or there are egregious attempts to overestimate costs.
There are three minimum essential requirements to a cost segregation study:
1) It classifies assets into property classes (e.g., land, land improvements, building, equipment, furniture and fixtures);
2) It explains the rationale (including legal citations) for classifying assets as either § 1245 or § 1250 property (sections which will be covered later in this article); and,
3) It substantiates the cost basis of each asset and reconciles total allocated costs with total actual costs.
You may think: ‘It’s only three, how hard can it be?’ While the IRS does provide pages and pages of instructions and explanations, the filing rules are complex and the preparation can take days, if not weeks. Some commercial real estate developers and other stakeholders have a hard time preparing correct and exhaustive studies for the IRS due to the daunting documentation, format requirements and evidence that needs to accompany them. The perception is that you have to become highly-versed in tax and accounting matters to do it, and for some small-scale entrepreneurs the whole process is too time-consuming and risky. That belief might have been a very rational, risk-based choice 20 years ago, but these days you can find knowledgeable and experienced specialists who will prepare the study accurately, so you can secure IRS approval to accelerate the recovery-cost of your real-estate investments.
At the heart of cost segregation studies lies the classification or reclassification of certain assets as depreciable over a shorter or longer period of time. This achieves recovery of some initial investments and costs earlier than the longest depreciable property. For instance, if the original total cost of a building is $10 million and that cost’s recovery normally occurs 39 years after the building was first placed in service, then the owner of the building can order a cost segregation analysis to allow him or her to recover the cost of certain components much sooner: in 5, 7 or 15 years. The IRS reviews such studies and then determines whether the assets listed are eligible for Section 1245 depreciation recapture or Section 1250 depreciation recapture, where the former identifies depreciable personal and real property that performs specific functions and the latter refers to buildings and more general structural components.
One of the best ways to prepare for depreciation calculations is to keep a record of all of the costs expended for these assets, individually, and as a lump sum, from the very beginning of the real property construction. Allocating the correct costs to each individual component of the structure or property and complying with the rest of the requirements, regardless of the calculation method or the study length, will shorten the review period by the IRS examiner by facilitating a precise overlap with IRS audit techniques.
There’s an additional depreciation category for components of real property which can be converted into personal property with shorter depreciation periods. That category applies to any qualifying property that can benefit from a first-year ‘bonus’ depreciation, as identified by the IRS in this list:
1) MACRS (Modified Accelerated Cost Recovery System) property with a recovery period of 20 years or less,
2) Depreciable computer software,
3) Water utility property, or
4) Qualified leasehold improvement property.
The bonus first-year deduction ranges from 30% to 100% for the year the property is first placed into service.
Before embarking on the preparation of the study itself, certain questions need to be answered about the property, and the IRS lays out the most important ones:
1) Is it the property you own?
2) Is it used in your business or income-producing activity? (You cannot depreciate property used solely for personal activities.)
3) Does it have a determinable useful life, i.e. it decays, becomes obsolete or wears out due to natural causes?
4) Does it last more than a year?
If the answer is ‘yes’ to all of these, then the owner can claim depreciation. If the property cannot be used for more than a year or is not used in your business, then it cannot be depreciated. An example would be any kind of magazine or journal whose useful life is only the time needed for one read-through. If purchased for a business, that publication becomes a business expense, but it cannot be used in a cost segregation study due to its short duration. Likewise, the inventory you hold in your warehouse has been purchased by the business, but it’s there only temporarily until it makes its way into the hands of the buyer. The IRS doesn’t see that inventory as something you’d use in the course of the business, but rather as something you hold onto for a while as part of your business activities. There are some exceptions to this, depending on the nature of your inventory and how you treat it in the course of your business.
In general, there are exceptions to most or all categories of assets. Some are less obvious, and some are really surprising, notably when personal property turns into business property through a change in its use, which starts the depreciation clock.
By now it’s clear that once the asset is placed in service, depreciation is triggered, but what happens when the asset is no longer in service? Depreciation stops because the business has stopped using the asset and, as a result, it is now playing no role in its income-producing activities, whether it is now obsolete, was destroyed or is affected by other applicable conditions.
In some cases, the asset is still part of the business, but it has become ‘idle’ or unused, due to various problems, specific to its industry. Malfunctioning machinery or delays in a supply chain can affect the level of utilization of an asset to the point where it becomes idle. In that case, depreciation continues until the asset has fully-depreciated or it has been offered for sale. Note that a hotel that is only open during the summer months continues to depreciate during the winter months when it has very little or no activity. The frequency of use here has no impact on its depreciation.
There are many moving pieces during the preparation of a cost-segregation study and report, but the benefits are worth the trouble. Another advantage of ordering a study is the acquisition of practice and knowledge which can be used to prepare future studies, bearing in mind that the rules may change slightly over time. Recovery periods may increase or decrease due to technological advances, climate changes or the replacement of traditional construction materials and equipment with newer, different ones. These are just a few of the reasons why it’s important to have a qualified professional prepare your cost segregation study.
Specialists commit their time to study the IRS guidelines and to constantly learning from previous IRS study reviews, always keeping in mind what reviewers look for in a cost segregation study. They look at the study and report through the examiner’s eye and identify inconsistencies, higher or lower prices than the actual costs, incorrect classification of assets, and any omissions in the explanations that support your classifications.
The work going into the study and the end product is fascinating, as building components are broken down and given a life within the guidelines of the six methodologies used by the IRS. When done properly and the deductions or refunds are approved, this early return of some investment to the property owner can infuse their business with new life and a healthier margin.