Cost Segregation Study: What are the tax benefits?

Business and individual taxpayers that acquire nonresidential real property or residential rental property have an opportunity to reduce the depreciable lives on assets which are considered building components.

Certain assets may qualify for shorter lives and recovery periods under Modified Accelerated Cost Recovery System (MACRS) depreciation. This reduction of the asset lives can accelerate deductions to offset income and offer an opportunity to reduce tax liability. 

The best mechanism to identify and reduce asset lives to accelerate depreciation deductions is a comprehensive cost segregation study.

Background

Generally, the entire cost of residential rental property is depreciated over 27.5 years. Nonresidential buildings, such as offices, retail space, grocery stores, restaurants, warehouses, and manufacturing plants are depreciated using a 31.5-year or 39-year depreciation period, depending upon the date of acquisition. However, under IRS cost segregation guidelines, a sizable portion of a building's cost can be depreciated over shorter periods. Certain building components may qualify for a reduced recovery period over 5 years or 7 years and qualified improvement property and exterior land improvements may qualify for a reduced recovery period of 15 years.

Examples of building components that may qualify for reduced recovery periods:

• Lighting
• Removable carpeting and wall tiling
• Furniture
• Counters and appliances
• Machinery (including machinery foundations) unrelated to the operation and maintenance of the building
• Portion of electrical wiring and plumbing properly allocable to machinery and equipment that is unrelated to the operation and maintenance of the building
• Land improvements such as:
  
  • Landscaping
  • Fences
  • Sidewalks
  • Curbs
  • Parking lots
  • Lighting
  • Utilities
  • Signs
  • Swimming pools
  • Tennis courts
  • Playgrounds

Qualified Improvement Property that may qualify for a reduced recovery period of 15 years, if these requirements are met:

• The property was placed in service after 2017
• The property was an improvement to an interior portion of a building that is nonresidential real property
• The improvement must be placed in service after the date the building was first placed in service by any taxpayer

Analysis and Cost Segregation Study

To determine the potential tax benefit, we can conduct a cost segregation study to identify the separately depreciable components and their depreciable basis. Ideally, a cost segregation study should be conducted prior to the time that a building is placed into service (i.e., when it is under construction or at the time of purchase). If a building is being purchased, the sales price can be allocated between real and personal property in the sales contract. However, a cost segregation study can be completed after a building is placed in service. 

State and Local Real Property Tax Reduction

Cost segregation may also result in the reduction of state and local real property taxes by reducing building costs allocable to real property. In addition, nearly half of all states provide sales and use tax exemptions for tangible personal property used in a manufacturing process or for research and development. A cost segregation study will identify such qualifying personal property.

Note: These tax savings depend upon the classification of the property as real or personal by applying applicable state law.

Energy Efficient Commercial Building Property Deduction

Cost segregation studies may be used to identify the following expenditures, prior and current, that may qualify for special energy efficient commercial building property deductions:

• Heating and cooling systems
• Ventilation
• Hot water systems
• Interior lighting systems
• Building envelope that qualifies for energy tax deductions

The amount of the deduction available depends on the tax year that the property is placed into service.

Reporting the Change to Depreciable Life

Generally, if the cost segregation study is done at the time the building is purchased or constructed, the reduced cost recovery periods and related depreciation deductions will be reported on the applicable income tax return for that year.

However, if the cost segregation study is performed in a later year, and if the assets qualify for a depreciable life change, those changes and related depreciation deduction adjustments must be reported on an amended return. An accounting method change would be completed instead if it is two or more years since the property was acquired or placed in service.

The IRS reporting would include the change of basis, depreciable life, and the adjustments made for the depreciation acceleration from the placed in-service date to the year the method changes.

Please contact your Herbein tax advisor for more information on how a cost segregation study may apply to your situation.

Article contributed by Noreymi N. Rivera