Cost segregation is the process of identifying and separating personal property, land improvements, and building components that can be depreciated for federal income tax purposes. The primary goal of cost segregation is to accelerate the depreciation deductions for certain qualified property, which results in a lower tax bill. As a result, more and more businesses today are turning to cost segregation studies to increase their cash flow and reduce their tax liabilities. In this article, we will be taking a closer look at the facts about cost segregation on assets, including how it works, who can benefit from it, and how to get started.
What is Cost Segregation?
Cost segregation is a highly specialized tax-planning tool that can significantly reduce the amount of taxes paid on commercial property investments. According to the IRS, cost segregation is a “”process of identifying property components that are eligible for accelerated depreciation deductions.”” In other words, the practice of separating real estate assets into various cost categories to give them different useful lives and tax benefits. The benefit of cost segregation is that it results in a higher amount of depreciation expense in the earlier years of an asset’s life (when the deduction is worth more), which lowers taxable income in those years.
How does Cost Segregation Work?
Cost segregation relies on the principles of engineering, accounting and tax laws. Engineers examine the physical components of property to uncover which elements can be identified separately for federal tax purposes. The engineer then identifies these components and determines their respective costs while an accountant uses the information to calculate the amounts for various depreciation schedules. Generally, buildings can be broken down into two main categories for cost segregation purposes: real property and personal property. Personal property can be further divided into five-year and seven-year property.
Real property includes the building itself and its structural components, such as the foundation, walls, roof, and flooring. Real property is generally depreciated over a period of 27.5 or 39 years, depending on whether it is a residential or commercial property.
Personal property, on the other hand, is depreciated over a shorter period of time, ranging from five to 15 years, and includes components within the building such as carpets, wall coverings, lighting, and cabinetry among other items.
By breaking down the components of a building, a cost segregation study can identify items that should be considered personal property and then allocate higher depreciation deductions to those items. This can lead to significant tax savings since personal property depreciates at a faster rate than real property, allowing for more expenses to be deferred sooner.
Who Can Benefit from Cost Segregation?
Any business or individual that owns commercial real estate or has recently made a significant investment in property can benefit from cost segregation. However, cost segregation is particularly advantageous for companies that have high tax liabilities and are seeking to optimize cash flow. It is also ideal for:
– Recently constructed buildings or those renovated or acquired within the last few years.
– Investment properties with a useful life of over 10 years.
– Properties for which the owner anticipates a taxable gain on sale.
– Buildings that have undergone a significant renovation, such as changes made to electrical or plumbing systems, roofing, and HVAC systems.
How to Get Started with Cost Segregation
The first step in starting with cost segregation is to consult a tax professional or cost segregation specialist. The specialist should be an expert in the field and should have a thorough understanding of both the cost segregation process and relevant tax laws. The specialist will also be tasked with managing the entirety of the cost segregation process, from conducting a physical inspection of the property up to finalizing the study and reporting back to the client.
During the initial assessment, the tax professional or cost segregation specialist will work with the client to review property information and the client’s financial needs and goals. They will also determine if a cost segregation study is necessary and will provide the client with a timeline and estimated costs. The cost of a study may vary depending on the size of the property, the extent of renovations, and the type of assets.
Generally, a cost segregation study begins with a site inspection where the specialist will gather information such as square footage, property history, renovations, and other relevant documentation. Following the inspection, the specialist will work to identify personal property components that can be depreciated quicker than the real property. They’ll determine and assign the appropriate tax life to the components of property in a detailed report to be submitted to the IRS.
Updating Cost Segregation in 2021
In recent years, there have been some changes to tax laws that affect cost segregation. The most significant change is outlined in the Tax Cuts and Jobs Act of 2017. Under the Act, bonus depreciation on qualified property was raised to 100 percent through 2022. Qualified property includes items such as computers, furniture, and machinery used in product manufacturing. This means businesses can immediately deduct the full cost of qualified property in the year of purchase.
This increased bonus depreciation could also impact cost segregation by providing additional incentives to assign a shorter useful life to assets wherever possible. For many property owners, cost segregation can be an effective strategy for reducing tax liabilities, and with the tax law changes in place, it is an even more attractive option.
Conclusion
Cost segregation can help reduce the tax obligations of real estate owners by accelerating depreciation deductions. It is a highly specialized and complex area of tax law that requires careful consideration. By consulting with a tax professional or cost segregation specialist, property owners can determine if a study is needed and avoid unnecessary mistakes that may lead to legal issues. If cost segregation is appropriate, significant tax savings can be realized, increasing both cash flow and property value. With up-to-date information like the changes to bonus depreciation under the 2017 Tax Cuts and Jobs Act, businesses can make informed decisions on whether cost segregation is the right asset strategy for them.
Cost segregation is used to lessen an individual’s immediate tax burden on assets that may depreciate over time. Cost segregation involves the separation of real estate assets that are grouped together with personal property assets, in order to have the tax burden imposed separately.
For example, real estate assets may have a quicker depreciation than personal assets, thereby lessening the immediate tax burden on those assets. Had those properties remained lumped together, it would be impossible to lessen the tax burden on those items that have a quicker depreciation.
In real estate, personal property may include items such as land improvements or other nonstructural elements such as the cost of construction of those nonstructural elements.
The value of real estate is estimated to depreciate over a period of around 30 years; however, the nonstructural items found within a building depreciate at a faster rate. Rugs for example, may depreciate at a rate of five years. Nonstructural elements which can be separated from the structure can include rugs, lighting, wallpaper, electrical systems and landscaping.
It is important however, that the property meets certain specific criteria before the assets are separated for cost segregation. For instance, the building must have been purchased or remodeled since 1987.
In addition, the cost segregation will likely only be beneficial when the cost of remodeling that structure or purchasing that structure, exceeded $200,000. It is also most beneficial for specific types of structures which have items that depreciate quicker, such as hotels or apartment buildings.
