Cost Segregation Analysis and Techniques

What is Cost Segregation?

A cost segregation study is a federal income tax tool that increases your near-term cash flow by deferring taxes. With a cost segregation analysis, you could be able to write off up to 30 to 35% of your building’s original purchase price in the first year!

Because depreciation occurs when a purchased building ages, it loses value over time. Actually, your building is not only one piece of property, but comprised of subcomponents (such as lighting fixtures, heating, and air conditioning systems, and other components that deteriorate over time).

But unlike the whole of a building, which is seen as having either a 27.5 or 39-year lifespan, subcomponents are granted a five- or 15-year lifespan, making the depreciation deduction larger, especially in the first several years.

Consequently, whether your property is residential or commercial, you can write off that cost either in a 27.5- or 39-year timeframe.

How Do You Know if an Engineering-Based Cost Segregation Study Is Right for Your Client?

Cost segregation studies are inexpensive. Often, the ROI for the building owner is very compelling.
Engineering-based studies will identify 25% to 50% of building costs that can be accelerated. This method is beyond the scope of what tax professionals will typically identify.
Cost segregation studies will perform well on buildings that are brand new as well as a building that has been in service for many years.
There is no need to amend a tax return.
Studies are frequently performed on buildings with a cost basis as low as $200,000.

Here Is How To Determine if Your Property Is a Viable Candidate for Cost Segregation:

Does your commercial or income property have a cost of at least $150,000?
Do you lease commercial space and have incurred buildout costs?
Does your commercial or income property have remaining depreciation?
Have you completed renovations in the last year?
Have you made frequent renovations during the ownership of your property?
Do you plan to own your building for at least five additional years?

Here Is an Example of Cost Segregation:

The best way to illustrate the effects of cost segregation is to compare a property with and without a study. Here are two scenarios:

1. A taxpayer purchases a mini-mall for $1.3 million, excluding land and personal property. If no cost-segregation study is performed, the taxpayer enters the cost into the fixed-asset system as 39-year property. After the first five years, the taxpayer has accumulated $154,622 in depreciation expenses.
2. After an engineering study combined with an understanding of what qualifies as short-life property as defined by Internal Revenue Code Section 1245, the mini-mall is reclassified into five-year ($260,524), 15-year ($348,590), and 39-year ($718,457) property.

The Result:
After the first five years, the taxpayer has a total of $460,545 in accumulated depreciation expense.

The obvious difference is that the taxpayer has increased the accumulated depreciation expense by $305,000. With a cost segregation study, the taxpayer has taken the majority of his depreciation up front and realizes that a dollar saved in the first five years is worth more than the same dollar in 16 years.

As a result, the taxpayer has a net present value savings of almost $100,000.

The distinction between what qualifies as short and long-life property has been shaped and reshaped during the last 20 years by court cases, private letter rulings, and Internal Revenue Service publications. With these ongoing changes, commercial property owners clearly can benefit from a properly documented cost-segregation study.