If you’ve acquired, constructed or
improved a building in the last three years,
you may want to consider a cost segregation study. A cost segregation study identifies
and reclassifies personal property assets
(nonstructural elements, exterior land
improvements and indirect construction
costs) to shorten the depreciation time for
taxation purposes, which reduces current
income tax obligations.
Analysis of capital expenditures is used to
determine appropriate asset classifications.
Cost segregation identifies building costs and
reclassifies them to permit a shorter, accelerated method of depreciation for certain
building costs. Costs for nonstructural elements (wall coverings, carpet, accent lighting, portions of the electrical system) and
exterior site improvements (sidewalks and
landscaping) can often be depreciated over
five, seven or 15 years.
“Cost segregation studies can be very beneficial,” says Kevin Lovins, CPA, a tax
shareholder with Briggs & Veselka Co. “Tax
depreciation deduction is accelerated,
which reduces income taxes and increases
cash flow. It should be noted, however,
that income taxes are only deferred, not
eliminated.”
Also, component costs are usually not easily identifiable and the IRS will not allow a taxpayer to estimate the components.
Smart Business asked Lovins about cost
segregation studies, how to conduct one and
why they are so helpful in today’s economy.
What problems can a company face when
acquiring, purchasing or improving real
estate property?
When the individual component costs of a
building are unavailable, the costs are generally classified as a 27.5- or 39-year property.
The acceleration of depreciation expense is
missed when the entire costs of a building is
classified this way. Generally, the individual
component costs of acquiring, constructing
or improving a building are not readily available. When purchasing a building, the cost is
usually just a lump-sum amount. Since
depreciation expense is missed, taxes are
accelerated and cash flow is negatively
impacted.
How does a cost segregation study work?
Usually, an accountant and an engineer will
analyze architectural drawings, mechanical
and electrical plans and other blueprints to
segregate the structural and general building
electrical and mechanical components from
those linked to personal property. The study
also allocates ‘soft costs,’ such as architect
and engineering fees, to all components of
the building. While the building itself and any
structural components are required to be
depreciated over 27.5 or 39 years, parts of a
building, including tangible personal property and land improvements, may qualify for an
accelerated deprecation method over a
much shorter recovery period (five, seven or
15 years). A cost segregation study identifies
costs eligible for accelerated depreciation
method over a shorter recovery period. By
identifying costs eligible for accelerated tax
depreciation expense, current taxes are
reduced, which improves cash flow. Taxes
are only deferred, not eliminated.
What are the benefits?
Cost segregation studies are performed by
trained tax and engineering professionals.
The professionals separate the individual
cost components by analyzing the construction drawings and methods and applying
their knowledge of the internal revenue code,
revenue rulings and court cases. A cost segregation study not only identifies the component parts of a building, but also substantiates the allocation of cost of a building
among the individual components.
In addition to providing tax relief, a cost
segregation study can benefit businesses by
maximizing tax savings by adjusting the timing of deductions. When an asset’s life is
shortened, depreciation expense is accelerated and tax payments are decreased during
the early stages of a property’s life. This, in
turn, releases cash for investment opportunities or current operating needs.
A cost segregation study also creates an
audit trail. Improper documentation of cost
and asset classifications can lead to an unfavorable audit adjustment. A properly documented cost segregation helps resolve IRS
inquiries at the earliest stages.
Finally, taxpayers can capture immediate
retroactive savings on property added since
1987. Previous rules, which provided a four-year, catch-up period for retroactive savings,
have been amended to allow taxpayers to
take the entire amount of the adjustment in
the year the cost segregation study is completed. This opportunity to recapture unrecognized depreciation in one year presents an
opportunity to perform retroactive cost segregation analyses on older properties to
increase cash flow in the current year.
What can go wrong if a cost segregation
study isn’t done?
If a taxpayer does not obtain a cost segregation study from a qualified professional,
the taxpayer may not be able to substantiate
his or her tax position upon challenge from
the Internal Revenue Service (IRS). The IRS
does not allow the taxpayer to estimate the
individual component costs.
KEVIN LOVINS, CPA, is a tax shareholder with Briggs & Veselka Co. Reach him at [email protected] or (713) 667-9147.
