Cost Segregation Depreciation Guide
Save tens of thousands on by significantly reducing your taxable income.
Cost Segregation Depreciation Guide is an educational guide to help investors understand, implement and maximize the tax strategy known as cost segregation.
Cost Segregation is a guide to reduce taxes and maximize cash flow while often paying for itself in a couple of years. Cost segregation benefits both real estate investors and business owners by allowing them to reallocate certain expenditures, which can help to reduce income and increase cash flow.
The goal of cost segregation is to apply specific percentages (which we call Cost Segregation Studies) to particular assets to determine their tax life for depreciation purposes. The results are summarized in a report, which usually consists of several categories for depreciable assets, such as:
- Land Improvements, which include parking lots, sidewalks, landscaping, and fencing
- Building & Structures
- Heating Ventilating & Air Conditioning Systems (HVAC)
- Plumbing Fixtures & Systems
- Electrical Distribution & Lighting Fixtures
- Elevators, Escalators, Monorails, Moving Walkways
- Building Components. This category includes cabinetry, floor coverings, ceiling tiles, etc. Note that this final component is not identified, inventoried, or evaluated by most cost segregation studies.
One of the biggest misunderstandings in property tax is depreciation. The concept that the federal government gives you a more significant write-off for certain assets usually falls squarely into the realm of confusingly complex and difficult to understand concepts. The idea is that pools, track groups, and components do not make this easier to grasp. Once you are familiar with the basics, we dive into more sophisticated topics such as campus grouping/track grouping/component depreciation techniques, accounting procedures, and beyond.
Real estate investors should also be aware that cost segregation is not a one-time strategy but an ongoing process. In other words, once your initial study has been completed, you can continue to add components and increase depreciation deductions over time.
Campus grouping/Track grouping is the division of building costs into external versus internal elements. A cost segregation study identifies all internal components as personal property, not structural elements. External features such as roofs, siding, windows, and exterior doors are separate components with a different estimated useful life under GDS/MACRS.
Most cost segregation studies are divided into two groups or “tracks.” The first track is commonly referred to as the tenant improvement track, which covers all interior components identified with a useful life of seven years or less. The second track is usually designated as the retail/commercial office component list, including features lasting more than seven years. The retail/office track is further divided into components that will last more than 25 years and components that are considered personal property.
The second is called the Building Component Depreciation List (BCDL). The BCDL is a long list of interior building components, most of which have useful lives of 39 years or less. The difference between tenant improvement and BCDL is that the latter separates components into two categories: those lasting longer than 25 years and those with a useful life of fewer than 25 years.
The most common method used by cost segregation studies is to group assets into three classifications. The first group consists of personal property assets, including building components such as cabinetry, lighting systems, and flooring. The second group is called land improvements, which includes all elements that form the permanent foundation, such as sidewalks, landscaping, and parking lot paving. The third group consists of structures such as walls and plumbing systems.
The process begins with evaluating original invoices and blueprints, which typically identify the type of asset, its location within the building, and its relation to the overall construction. Once all original invoices are gathered, they are carefully inspected by cost segregation professionals who attempt to determine useful life based on industry standards. When useful life has been established for each component listed on an invoice, depreciation is calculated using the Modified Accelerated Cost Recovery System (MACRS).
Component depreciation is a process that assigns specific asset lives to individual building components (again – defined as everything within the building except structural). The IRS states that buildings and their structural elements should be depreciated over a 27.5, 39, or 45-year life (based on the type of construction). Still, personal property components might have lives as short as 5 years or even <1 year for something like an HVAC system.
Accounting procedures and reporting are also crucial benefits of cost segregation. The IRS allows real estate owners to use different accounting methods for depreciating personal property versus the building structure itself. This means that if your client structures their ownership, the depreciation flows through from an LLC or Partnership. They can often take advantage of lower tax rates on business income because the personal property, which is depreciated over five years or less, can be written off with no impact.
Cost Segregation Depreciation Guide Frequently Asked Questions
What is a cost segregation study?
A cost segregation study identifies and reclassifies personal property assets to shorten the timeline for depreciation expenses.
What is the difference between a cost segregation study and an IRS audit?
An IRS examination (audit) assigns (or declines) depreciation expenses based on whether or not the asset has been appropriately classified into the correct class. The cost segregation study identifies the personal property assets, their respective lives and assigns depreciation to each asset based on its individual life.
How does a cost segregation study shorten the depreciation timeline?
The more of the building components you can classify as 5-, 7- or 15-year property instead of 39- or 27.5-year property, the faster you can take these expenses and depreciate them over a shorter time. This grouping is called Modified Accelerated Cost Recovery System (MACRS), which is required by tax law to be depreciated over various useful lives depending on the type of component being expensed.
Can repairs and upgrades be depreciated?
Suppose you improve a building component and the physical life is extended. In that case, the reallocated cost can be allocated to shorten the depreciation expense on another asset within Modified Accelerated Cost Recovery System (MACRS). Improved lighting, for example, may result in extending the life of the carpet or paint up to 5 years and allocating those expenses to shorten the depreciation expense of other 5-, 7- and/or 15-year property.
Can I do a cost segregation study on my own?
It will help if an engineering professional is familiar with tax codes and IRS procedures to perform a cost segregation study. Any improper reallocation of assets may result in IRS penalties.
I just had my building appraised for a refinance or sale, but the appraiser did not mention this study. Why is that?
An appraisal is just an opinion of value based on similar properties in your area and the market conditions at the time. While it will show any extraordinary expenses such as solar panels, double-pane windows, or other upgrades, it will not identify the depreciation benefit of personal property assets.
How much time can you save during an IRS examination (audit)?
The more accurate your report is (and depending on the complexity of your entity), you may be able to reduce the audit time by 40% or more.
What if I close my depreciable assets in the middle of the year?
When you file at mid-year (June 30th, for example), any depreciation expense taken must be prorated based on the number of days you were open and active in the business that year divided by 365. This is called a mid-year convention.
What if I close my depreciable assets at the end of the year?
When you file at year-end (December 31st, for example), any depreciation expense taken must be prorated based on the number of days you were open and active in the business that year divided by 365. This is a mid-year convention.
What is a building component?
A building component can be hard or soft, but most commonly refers to the interior finishing components of a commercial building such as walls, ceilings, flooring, and cabinets.
How do I determine if my asset is a depreciable asset or not?
Depreciable assets are installed into a building to extend, maintain or improve the functional use of the building. Generally, these types of assets should be capitalized and depreciated over their respective lives. Personal property assets such as furniture, equipment, and other office furnishings unrelated to the building structure should be expensed (or de-capitalized) annually.
What are the benefits of a cost segregation study?
A cost segregation study identifies the personal property assets, their respective lives and assigns depreciation to each asset based on its individual life. This can result in accelerated depreciation, tax savings, and potential cash flow advantages during the ownership of the commercial building.
How long does a cost segregation study take?
The process only takes a few days, but the report can be several hundred pages. Be aware of any company that offers a cost segregation study in 24 hours. This is impossible to perform without an engineering professional who can conduct a thorough and proper analysis.
Cost segregation delivers results every time it is performed. Since the first cost segregation study was completed in 1986, over 95% of all commercial cost segregation studies have accelerated depreciation.
What is the difference between a tax credit and a tax deduction?
Tax credits are always 1:1 (one dollar back for one dollar spent), while tax deductions yield a percentage of your income. For example, the new tax bill allows up to $1,000,000 of net income losses on your personal taxes each year. A loss is a deduction and cannot be more than the amount of taxable income. Credit is not limited as long as you qualify for it, and total credits can be more significant than 100% of your tax liability.
A good rule of thumb is to always look for tax credit opportunities first before considering a deduction.
How do I report this on my income taxes?
A completed cost segregation study must be provided to all your tax advisors before reporting the benefits on individual returns. Any company that offers you a “one size fits all” package or software tool is not guaranteeing you the most accurate results available.
How do I get my building reclassified?
A cost segregation study must be performed with an engineering professional to provide your legal and tax advisors with the information necessary to complete a reclassification. The cost of conducting a study can vary greatly depending on various factors but generally ranges from $1,500 to $4,000.
As a property owner, you can petition your local government to reclassify the real property based on the study performed. This is called a Petition for Revaluation or an Equalization Petition and must be done before any tax implications are affected.
A cost segregation study also provides the engineering data necessary to establish the cost basis of personal property assets. This is useful when you buy or sell assets that are installed into commercial real estate.
What if I can’t afford a study?
Often, cost segregation studies are confused with depreciation recapture studies. Cost segregation studies don’t change your taxes or the way your building is depreciated but only reclassifies the real property.
Cost segregation studies identify and segregate all of the individual components of a commercial rental property that can be depreciated over shorter lives than the entire asset (building). Even if you can’t afford to perform a study, every commercial property owner should know what the new tax law provides. For example, further five-year depreciation for personal property assets installed in commercial real estate will enable many more property owners to realize the maximum benefit of the recent tax legislation.
What are the most common cost segregation studies performed?
As mentioned above, each state has its list of assets that may be reclassified under federal tax law (previously known as the Modified Accelerated Cost Recovery System or MACRS).
The most common cost segregation studies performed are multi-story apartment buildings, restaurants with cook/holding ovens, retail stores, and hotels.
What is the best practice to assure all components are cost segregated?
The best practice is to hire your cost segregation firm before the purchase. The engineering study, along with a knowledge of the potential land value and building contents, will give you the best opportunity to maximize all accelerated depreciation schedules.