Looking for tax savings? For clients who are in the real estate, construction, and other related industries cost segregation can be a significant way to take advantage of depreciation up front!
A cost segregation analysis is the process of analyzing and reallocating engineering-based costs relating to the construction, renovation or acquisition of a building. Cost-segregation studies, which analyze the components that make up the building and assign each with recovery periods offer real estate and construction professionals tax advantages.
Assets are depreciated over 5, 7, or 15 years, using an accelerated method, rather than the standard 27.5-year or 39-year straight-line method used for most real estate where the assets are gradually reduced over time. This could result in additional accelerated deductions and increased cash flow.
Essentially, all taxpayers in the commercial real estate industry – contractors, renovators, purchasers, and investors – may benefit from a cost segregation study to determine which of their properties qualifies for accelerated depreciation. If you are purchasing an existing building, constructing a new building, expanding or renovating a building you already own, then you can derive benefits from a cost segregation analysis or study.
The best candidates for a study like this tend to be properties that have a depreciable cost basis of around $1 million or more. For a leasehold improvement project, this drops to around $300,000. This means that the companies that can benefit most are large scale property developers or real estate owners of higher value properties.
Benefits of performing a cost segregation analysis include:
- Accelerate depreciation
- Increase current tax deductions
- Defer income tax
- Increase cash flow
- Provide other additional opportunities like property tax and future retirement
If you are a client who owns or manages multifamily properties, cost segregation might be the biggest source of tax savings that you’ve overlooked. Like any building, multi-family properties depreciate, or lose value, over time, due to everyday wear and tear that accumulates. But rather than calculating an apartment building’s depreciation via the traditional method of dividing the improved value by 27.5 years, a cost segregation study analyzes a property’s distinct components, sorts these components into different categories eligible for an accelerated depreciation schedule which can reduce taxable income and increase after-tax cash flow substantially.
In a cost segregation analysis, the client’s property elements are divided into two categories: real property, which includes permanent and immobile objects, like their building’s foundation, and personal property, which includes objects like kitchen cabinets and flooring. While the real property components depreciate over a period of 27.5 years, the personal property components depreciate over shorter periods: five, seven or 15 years, depending on the specific element. Cost segregation speeds up depreciation so you can deduct more from your taxes.
A cost segregation study categorizes a property’s components into four classes; each is depreciated over a different time period that reflects to the asset’s useful life:
- Personal property: includes items such as furniture, carpeting, fixtures, and window treatments. If you depreciate these over five or seven years using the double declining method, you can significantly increase the depreciation expense for these items.
- Land improvements: includes items such as sidewalks, fences, and docks. Using the double declining balance method, you can depreciate them over a 15-year period. It’s advisable to maximize the values attributed to this category.
- The building: includes the building’s components, such as the roof and plumbing systems. You should seek to allocate the maximum value you can to this category, because any residual value is attributed to land.
- Land: You allocate any amounts not allocated to the previous three categories to land and depreciate them accordingly.
Various property types that can benefit from cost segregation analysis include, but are not limited to:
- Manufacturing and industrial plants
- Health and long-term care facilities
- Financial institutions
- Automobile dealerships
- Distribution centers and warehouses
- Office buildings
- Restaurants and hotels
- Retail and convenience stores
- Shopping centers
- Apartment buildings
The best time to conduct a cost segregation analysis is the year that the property is placed in service. It is most beneficial to maximize depreciation deductions from the first year, whether the property is new construction or a new acquisition. An under-utilized practice known as “tax engineering” can also be employed by companies and architects at the blueprint stage to incorporate building designs that will enhance tax savings for years to come.
The cost of a cost segregation analysis can vary greatly, depending on the size, type, and complexity of the property, as well as the quality of the provider and their work product. The fee for a cost segregation analysis should be cost based on time and materials, or on a fixed fee basis, but never on a contingency basis (for example, a percentage of the savings made). It isn’t unheard of a cost segregation study to generate hundreds of thousands of dollars in net present value savings.
Worried a cost segregation will put you at risk of an IRS audit? You are at no greater risk with new assets, newly constructed or a new acquisition, than you are by filing a regular income tax return. A look-back study will not require filing an amended return, but will require the taxpayer to file a change of accounting method, which will then be reviewed by the IRS office.
Reach out to us: A cost segregation study can save money and improve cash flow. Maintenance, rent collection, and tenant placement is important, but tools like cost segregation improve clients’ returns, so let us introduce you to this value-added service. The preparation of a cost segregation study requires knowledge of both the construction process and tax law involving property classifications for depreciation purposes. This is one of the reasons it is so important to work with a qualified and experienced consultant. Contact us at 855-542-7537 or CPA@fuoco.com.