Cost segregation studies identify costs related to real property that can be reallocated to a short-life deprecation schedule. These studies are one of the most valuable tax saving strategies available for commercial real estate owners, leaseholders and others. For real estate owners who are not familiar with cost segregation studies, there may be an opportunity to leverage this tool to realize a significant tax savings. To help our clients, prospects and others understand the benefit of a cost segregation study, Smith Schafer has provided a summary below.
About Cost Segregation Studies
The purpose of a cost segregation study is to identify assets and their costs related to a real estate purchase or reconstruction and classify those assets for federal tax purposes. Certain costs previously subject to a 39-year depreciable life can instead be classified as personal property or land improvements with a 5-, 7-, or 15-year rate of depreciation using accelerated methods. By accelerating a buildings’ depreciation, property owners are able to receive tax benefits much more quickly.
A cost segregation study can be performed at the time of property acquisition or construction and is typically implemented on the first tax return for the property. The IRS also allows taxpayers to perform a cost segregation study on a building placed in service during a prior year and “catch up” the additional depreciation amount without an amended tax return.
Cost segregation studies must be engineering-based, typically involving professional engineers to review all the costs associated with the building or building improvement along with a CPA to provide itemized details for tax purposes. The study examines a wide range of building components, such as electrical installations, plumbing, mechanical components, HVAC and finishes. It also involves a physical inspection of the property, analysis of architectural and engineering drawings, and review of cost data, including the contractor’s application of payments, material components, change orders, owner-incurred costs, and indirect disbursements.
Costs are broken out into their appropriate categories: indirect costs (which are later broken into either personal and real property categories), direct costs related to personal property, and direct costs related to real property. Indirect costs include architect fees, interior design fees, engineering costs, and other miscellaneous construction costs. Direct costs related to personal property include machinery, equipment, furniture, and fixtures. Direct costs related to real property include the building itself, fire protection and alarm systems, flooring, doors, and the HVAC system.
Cost Segregation Tax Savings
As a result of a cost segregation study, a business owner can depreciate property over the shortest permissible period of time. For instance, the study may identify electrical or plumbing costs related to the operation of machinery and equipment, which is generally depreciated over five years. This reallocation of cost increases cash flow by reducing the overall tax burden. The tax savings created by depreciating more assets as personal property usually more than make up the expenses paid to perform the study.
In a typical cost segregation study, between 15% and 45% of a building’s costs can be reclassified to shorter-life assets, depending on the type of facility. For a $1 million project, this can equal between $30,000 and $90,000 in increased cash flow. This allows further investment or even quicker repayment of the loan on the building.
Many real estate investors, who already own, construct, renovate, or acquire property – especially property worth more than $1 million or improvements that cost more than $500,000 – can benefit from a cost segregation study. If you are interested in learning more about cost segregation studies and how one can benefit you, Smith Schafer wants to help! Click here to start the discussion. We look forward to speaking with you soon.