By David DeGrand
Cost segregation studies are an established tax strategy available to owners of commercial and residential real estate. Yet, cost segregation remains one of the more underutilized tax strategies available. With the increase in new building construction, properties exchanging hands as prices rise and older properties being remodeled and renovated, cost segregation studies can provide an immediate tax benefit.
The new tangible property regulations have also increased the value of cost segregation studies, which may provide a basis for property that is demolished, retired or removed and that qualifies for dispositions expensing. Additionally, future repairs expensing may be facilitated through the proper identification of units of property and major components of buildings.
Cost segregation studies identify property that can be allocated to shorter depreciable lives than 27.5 years for residential property or 39 years for commercial property. Shorter depreciable lives in the early years provide larger depreciation deductions.
This results in lower taxable income and increased cash flow from lowered taxes. The amount of shorter life property identified in a building can vary widely depending on the type of building. Every generic building is going to have a foundation, walls, a roof, windows, electrical outlets, plumbing and HVAC systems. These are normally considered real property under section 1250 of the IRS code and depreciated over 27.5 or 39 years. It's the building components that exist to support the business functions of the building that are normally identified as shorter life property, either section 1245 tangible personal property or land improvements.
Section 1245 tangible personal property is normally found on the inside of a building and is there to support the business aspects of the property.
Examples include built-in cabinetry, glued-on surfaces such as carpet or tile, decorative lighting, television/cable/computer equipment connections, demountable partitions, window coverings, telephone systems, machinery and equipment, electrical and plumbing connections, emergency generators and many other components. Land improvements, which may be either section 1245 or section 1250 property, are normally found outside the building and include fences and walls, lighting, paving, walks, roads, storm drainage, retaining walls, landscaping, irrigation, wheel stops, pipe bollards and other components.
The depreciable life of section 1245 tangible personal property is normally 5 or 7 years. Under MACRS, the class life for assets are determined by the activity class. The most common activity class for cost segregation is 57.0 Distributive Trades & Services which has a 5-year life for section 1245 property. Many manufacturing activity classes depreciate the same type of assets over a 7-year life. Land improvements generally have a 15-year depreciable life.
The federal PATH Act of 2015 extended some taxpayer favorable provisions for cost segregation that previously expired at the end of 2014. Fifteen-year depreciation for qualified leasehold improvements (QLHI), qualified restaurant improvements (QRP), and qualified retail improvement property (QRIP) are now permanent provisions.
QLHI is eligible for bonus depreciation. Bonus depreciation is additional depreciation taken for new construction in the year it is placed in service for building components with depreciable lives of less than 20 years. Cost segregation identifies property in a building that is less than 20 years. Bonus depreciation has been extended at 50 percent for 2015-2017, 40 percent in 2018 and 30 percent in 2019.
It's not just newly acquired, constructed or renovated buildings that can benefit from a cost segregation study; it also includes buildings placed in service in previous years. IRS Revenue Procedure 2015-14 allows taxpayers to go back and reclassify assets to their proper shorter recovery periods. The additional depreciation is recovered in the year the change is made via a section 481(a) adjustment.
With an increase in real estate activity, the PATH Act extending tax incentives and the Tangible Property Regulations providing expensing opportunities, there has never been a better time to consider cost segregation. Experienced cost segregation providers can provide accurate estimates of the potential tax benefit at no cost. Now is the time to look at the tax benefits cost segregation can provide.
