Cost Segregation is the Internal Revenue Service recognized practice of identifying real property assets and their related costs and classifying those assets for federal and state income tax purposes.
The benefit of cost segregation is the increase in cash flow during the early years of building ownership measured by the present value of that increased operating capital. Every $100,000 of asset value re-classified from 39 year property to 7 year property will produce approximately $20,000 of increased cash flow (net present value of the tax benefit assuming the highest marginal tax rate and an 8% discount rate).
Benefits of Cost Segregation
A Cost Segregation Study can:
- Immediately increase cash flow created by accelerated depreciation of certain assets
- Reduce income and possibly real estate taxes
- Create an opportunity to “catch-up” depreciation not previously recognized
Properties that Qualify for Cost Segregation
Generally, any facility used for commercial, industrial or commercial-residential purposes will benefit from performing a cost segregation study. The chart below represents the typical range of construction related costs that could be reclassified from 39 or 27.5 year real estate depreciation schedules to 15, 7, or 5 year depreciation schedules for federal and state income tax purposes.
Leasehold improvements also qualify for cost segregation. In many cases, interior build-outs produce proportionally greater ratio of tax savings when compared to a stand alone structure.
|TYPICAL ACCELERATED DEPRECIATION|
|Apartments/Multi-Family||20% – 40%|
|Assisted Living||15% – 30%|
|Automobile Dealerships||25% – 50%|
|Banks||15% – 30%|
|Computer/Technology Centers||20% – 60%|
|Fitness Centers/Health Clubs||20% – 30%|
|Golf Courses||20% – 40%|
|Grocery Store||20% – 30%|
|Hotels/Motels||20% – 30%|
|Heavy Manufacturing||30% – 60%|
|Light Manufacturing||20% – 40%|
|Medical Office/Ambulatory Care||20% – 40%|
|Office Buildings||20% – 40%|
|Research and Development Facilities||20% – 60%|
|Restaurants||20% – 40%|
|Retail Stores||20% – 30%|
|Self Storage Facilities||20% – 70%|
|Shopping Malls/Regional Centers||10% – 30%|
|Tenant (Leasehold) Improvements||10% – 50%|
|Theaters||20% – 30%|
|Warehouses||5% – 15%|
Timing for a Cost Segregation Study
When to conduct a cost segregation study will depend on your particular tax situation. We perform an analysis of your tax basis prior to performing the study based on the tax strategy that is best for the client.
Some general triggers to perform a cost segregation study are:
- Prior to construction
- During or immediately after construction
- Post-purchase of an existing facility
- After a major remodel or addition
The best time to perform a cost segregation study is during the year the facility is placed in service. This allows for immediate tax savings and properly classifies the assets when they are initially capitalized. The earlier the cost segregation specialist is engaged will result in a more accurate and less costly study.
The IRS procedures do provide a catch-up provision for properties initially placed in service without the benefit of a cost segregation study. These “Look-back” studies make it easy to reclassify assets into their proper depreciation classification without amending prior tax returns, allowing property owners to claim missed depreciation going back as far as 1987.
The Cost Segregation Report
The elements of a quality cost segregation report are outlined in the IRS Audit Technique Guideline. There is no standard format for the report but a well documented cost segregation study will include:
- An assemblage and analysis of all relevant construction documents where they exist including the contractor’s applications for payment, construction invoices for goods or items purchased outside the general construction contract, change orders, appraisals, and other documents relevant to the facilities construction or acquisition.
- A physical inspection of the facility and interviews with the building owners and occupants to gain a thorough understanding of the building and its use allowing for proper classification of the assets.
- Documentation of the assets including photographs, plans and specifications, and any other supporting information used in the cost segregation study.
- Take-off and estimate of the construction costs of the real property and all assets to be re-classified as personal property.
- Reconciliation and preparation of the cost segregation report including all supporting documentation used to develop the study, reported in a format acceptable to and in accordance with the IRS and the Audit Techniques Guideline.
The Experience Required
A quality cost segregation study is performed by organizations and individuals with many different skills and a breadth of knowledge and experience. Some of the experience and understandings required include:
- Construction, tax, engineering and valuation knowledge and experience to accurately identify and quantify the assets eligible for cost segregation.
- Knowledge of prior court cases and contemporary tax law when applying the principles of cost segregation. Since there is no “Bright Line Test” for identifying personal property therefore a cost segregation is subject to a facts and circumstance analysis.
- Compliance with the Audit Techniques Guideline to ensure the study will withstand IRS scrutiny in the event of an IRS audit.