What is Cost Segregation?
Cost Segregation is the practice of identifying assets and their costs, and classifying those assets for federal tax purposes. In a cost segregation study, certain commercial building costs previously classified with 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. Residential buildings, including multi-family buildings are subject to a 27.5 year life. An “engineering-based” study allows a building owner to depreciate a new or existing structure in the shortest amount of time permissible under current tax laws.
The benefits of a cost segregation study include:
- An immediate increase in cash flow
- A reduction in current tax liability
- The deferral of taxes
- The ability to reclaim “missed” depreciation deductions from prior years (without having to amend tax returns)
COST SEGREGATION DEFINED
“Engineering-based” cost segregation enables commercial real estate owners to reallocate real property (under Code Sec. 1250) to personal property (under Code Sec. 1245). This results in a substantially shorter depreciable tax life and accelerated depreciation methods.
WHY A SPECIALIST IS NEEDED
For both new and existing properties, the IRS requires that engineering-based cost segregation studies be performed in order to realize the maximum depreciation benefits. Engineering-based cost segregation services provide more precisely segregated property information, giving CPAs the information and detailed supporting documentation they need to meet with strict IRS regulations and requirements for audit defense.
In the IRS Cost Segregation Audit Techniques Guide (ATG), Chapter 4, the prime attribute of a high-quality cost segregation analysis is “preparation by an individual with expertise and experience.” The Audit Techniques Guide adds: “Preparation of cost segregation studies requires knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. Experience in cost estimating and allocation, as well as knowledge of the applicable tax law, are other important criteria.”
WHAT TYPES OF ITEMS ARE IDENTIFIED?
Through an engineering-based cost segregation study, a wide range of building components, such as electrical installations, plumbing, mechanical components, and finishes can be identified and reclassified into shorter-lived asset classes. This adds up to substantial savings to the client.
WHAT ROLE DOES “TIME VALUE OF MONEY” (TVM) PLAY?
Cost segregation is based on the fundamental principle that “a dollar today is worth more than a dollar tomorrow”. The same logic applies to the statement: “a tax deduction today is worth more than a tax deduction tomorrow”. By accelerating a buildings’ depreciation, property owners can lower their tax liability and thus realize a significant increase in cash flow. This larger cash flow—resulting from postponing tax payments—is available for other investments.
“The major advantage of cost segregation is not necessarily that it will produce more depreciation deductions. Instead, due to the time value of money, the advantage of these front-loaded deductions will be quantifiably greater than had the deductions been spread over longer periods of time using slower depreciation methods.”
Journal of Accountancy
© 2005 by the AICPA
THE IRS’s AUDIT TECHNIQUES GUIDE (ATG)
In late 2004, the IRS released the guidelines their agents must follow for audits of cost segregation studies. This guide reviews the methodologies recognized by the IRS for asset allocation. It examines the various characteristics of a quality study. Referring to the “detailed engineering approach,” the guidelines state: “In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation.”
THE BOTTOM LINE
Cost segregation studies are one of the most valuable tax strategies available to owners of commercial real estate today. This increasingly popular tax strategy offers facility owners the opportunity to defer taxes, reduce their overall current tax burden, and free up capital by improving their current cash flow. Virtually every taxpayer who owns, constructs, renovates, or acquires a commercial real estate structure stands to benefit from a cost segregation analysis. By engaging the expertise of Ernst & Morris, property owners can be assured that their study will stand up to the strictest scrutiny of IRS auditors. Ernst & Morris has been performing cost segregation studies since 1993 and has vast experience defending cost segregation studies during IRS inquiries and audits.
According to a recent article in the AICPA’s Journal of Accountancy,
“Selecting a firm that uses qualified professionals with years of significant, relevant experience can be an important differentiator in the quality of a cost segregation study.”
Journal of Accountancy
© From the AICPA