Cost Segregation: Tax Savings Hidden in Your Walls

By: Lynn A. Conover, CPA

Many commercial property owners may be able to take advantage of a service to help them increase tax savings and cash flow benefits available to them. This service, known as cost segregation, is recognized by the Internal Revenue Service and requires a blend of knowledge in engineering, tax and accounting. Cost segregation studies identify and break out personal property components and land improvements from the structural building costs allowing the taxpayers to reclassify them into shorter depreciation lives in order to maximize depreciation expenses. Generally, real estate properties are depreciated using a straight-line method over 39.5 years for commercial properties and 27.5 years for residential properties. The goal of cost segregation is to reclassify a significant portion of the costs to a shorter recovery period and accelerate the deprecation deductions to save tax dollars now rather than later.

What are some types of items a cost segregation specialist looks for?
Assets are grouped under several asset depreciation range classifications which include office furniture, fixtures and equipment, information systems, land improvements, and manufacture of electronic components, products and systems among others. Their accelerated tax lives range anywhere from five to fifteen years rather than the straight line 39.5 or 27.5 years. A cost segregation professional will identify which components of each system that can be assigned into each of these categories of accelerated tax lives.

If a cost segregation professional were to study an office building, he or she would look for electrical allocation for site lighting and lighting signage, audiovisual equipment, telephone and security equipment. An office building might also include countertops, folding partitions and cabinetry. Some examples of items to look for in an apartment building would be plumbing allocation for kitchenette sinks, garbage disposals, washers and dryers among other appliances. A retail building might include a retaining wall located in a masonry contract.

Some questions a specialist might ask in order to determine if the accelerated items exist would include: Is there more than one power source in your office? Do the walls of your office penetrate the ceiling tiles, and are they load bearing? Is the decorative paneling in an office area glued, nailed or hung on the wall? Is your cooling system oversized in order to cool your data-processing room? Do you have a kitchen?

When is a cost segregation study necessary?
Generally, a cost segregation study will be feasible for projects with a building cost greater than $750,000 excluding land. The threshold decreases to $500,000 for leasehold improvements. A taxpayer should consider a cost segregation study if they have recently started or completed a construction project. A recent real estate acquisition may require a purchase price allocation study. If a taxpayer acquired real estate within the last 15 years and did not previously analyze the property, they may still be able to take advantage of this accelerated calculation by obtaining a retroactive cost segregation or purchase price allocation. In addition, a cost segregation study might come in handy if a taxpayer received property from an estate that will have a step up in basis. In this case, a fair market value allocation service will be required.

The types of facilities that have benefited from cost segregation studies include restaurants, real estate investment trusts, office buildings, senior living facilities, golf courses, hotels, apartment buildings and strip malls among others. Their building construction and acquisitions costs have ranged from two to ten million dollars. The present value savings over their total tax lives ranged from $95,000 to $800,000 depending on the conditions of each situation.

Is it possible to have a retroactive cost segregation study done?
Yes, it is possible to retroactively perform a cost segregation study for assets placed in service in previous years and capture tax savings for the property owner. In fact, the IRS allows a taxpayer to consider asset acquisitions back to 1987 (when MACRS was introduced). No amended tax returns or IRS approvals are required for this. If two or more tax returns have been filed on the property, the taxpayer will file a Form 3115, Change of Accounting Method with the current year tax return. A Section 481(a) adjustment is then captured on the current year Form 4562, Depreciation and Amortization, to adjust the property’s federal tax position from the straight line 39.5 year (27.5 for residential property) depreciation to the new accelerated depreciation mapped out in a cost segregation study. These forms can be prepared by the taxpayer’s CPA or the cost segregation team.

Short-term depreciable items are then put through a correction schedule and the overpayment in tax is returned to the property owner over the next four years. For example, if the building has been in a portfolio for five years, all the five year components should have been fully depreciated, but instead only 5/40 were depreciated. The owner may now recoup the 35/40 remaining life spread over the next four years. Seven year components in this example have been 5/40 depreciated, but should have been 5/7 depreciated.

What information is required for a cost segregation study?
A cost segregation specialist can perform a nonintrusive yet detailed engineering study of a building’s walls, flooring and ceilings, and its plumbing, electrical, lighting, telecommunications, heating and cooling systems. They prefer to work with building plans and cost documents rather than relying strictly on a building tour in order to provide maximum benefit.

Some information that may be required for a cost segregation study of new construction would include general contractor payment applications, subcontractor payment applications, owner capitalized project costs, change order detail, site survey with legal descriptions, architectural drawings and mechanical, electrical and plumbing drawings. In the event of an asset acquisition, where a purchase price allocation may be required the specialist will need recent property appraisals, recent property condition reports, site survey with legal descriptions, architectural drawings, mechanical, electrical and plumbing drawings, utility drawings, total adjusted purchase price, acquisition date, leasing plans, and copies of lease abstracts.

In conclusion.
It is extremely important to obtain the services of an experienced cost segregation provider in the event the IRS inquires about the cost segregation study three or more years down the line. A good provider will be able to stand behind the work he or she has done. A cost segregation study is based on well-founded interpretations of the Internal Revenue sections, applicable court cases and revenue rulings. The cost segregation professional you choose should be able to demonstrate the relationship of the analysis to relevant laws, rulings and precedents as support for the positions recommended in qualifying components as accelerated depreciable property.

About the Author
Lynn A. Conover, CPA is a partner at The Curchin Group, LLC, an accounting firm located in Red Bank, NJ which provides accounting, auditing, tax, and consulting related services to individuals and businesses in the construction industry.