Cost Segregation Questions / FAQs
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Have any questions about cost segregation? Our cost segregation FAQs can help answer the most common questions.
What is a Cost Segregation
The economic benefits of cost segregation are significant, especially when you are building a new commercial property. Cost segregation is the process of identifying all tangible personal property and specific improvements that can be depreciated over shorter tax lives (5, 7, and 15 years) than the typical 27.5 or 39-year life to which they would otherwise be subject. Not only does this lower the property taxes over the shorter tax life, but it also accelerates depreciation deductions into those periods and reduces overall income tax liability for both federal and state purposes.
Cost segregation identifies and reclassifies personal property assets and reallocates the depreciation associated with those assets to the tax year they were first placed into service, thereby accelerating depreciation deductions for tax purposes.
However, cost segregation is not a new concept, and it has been part of our tax code since 1954, when Congress passed what is known as “The Little Hoover Commission.” This provision provided that if taxpayers were to engage in accelerated depreciation methods, the IRS would be limited to a “reasonable” amount of depreciation.
In addition, cost segregation also reallocates the GST exemption from the land to the building, thereby increasing it from $1 million to $1.07 million in assets placed into service after May 1987 and before January 1, 2005. This process reduces income tax over a five- to seven-year period that reflects the accelerated depreciation deductions.
This is a potent tool for commercial real estate property owners, but why haven’t all properties taken advantage of this opportunity to accelerate their depreciation deductions? The reason is simple: compliance costs outweigh the benefits, which have been neglected.
What types of properties does cost segregation impact?
The most commonly seen commercial real estate projects that benefit from cost segregation are retail buildings, shopping centers, restaurants, medical buildings, office buildings, and distribution centers.
What are the benefits of cost segregation?
The benefits of cost segregation can be seen in three primary areas: Cash Flow – Cost segregation significantly reduces property tax payments with an immediate increase in net operating income (NOI). In addition to lower taxes each year, the accelerated depreciation benefits future cash flow. Income taxes – Cost segregation reduces income tax liability in both the year the property is placed in service and at the end of the asset’s life when it is sold or otherwise disposed of. Cash value – cost segregation helps commercial real estate owners leverage their properties with lower tax burdens, higher NOI, increased equity, and increased asset value.
What financial items does cost segregation affect?
Two of the most significant tax benefits are highlighted below: Property Depreciation. With proper planning, a commercial property owner can accelerate 100% of their building’s depreciation in the year of construction or other improvements over a shorter 15-year GDS recovery period for tangible personal property and a 7-year ADS recovery period for specific improvements using cost segregation. Accelerated depreciation is not available if the project was placed in service before 1986. Energy and water efficiency: Cost segregation identifies significant components of the building that can be separated from the land and depreciated over 5, 7, or 15 years. This treatment allows commercial property owners to take advantage of the highest energy and water efficiencies that may not be available in typical commercial loans.
What is the process for applying cost segregation?
The first step is to identify all assets and components on a project by reviewing blueprints and schematic drawings (floor plans). Then you need to perform a full-scale inspection, which includes a physical walk-through an assessment of the entire asset, including any improvements that have been added or built since construction. At this point, all components should be delineated and segregated into shorter lives for depreciation purposes.
When would I use Cost Segregation?
Cost segregation delivers results when two conditions are met: 1) The building is a new construction project, and 2) Your client has not previously claimed the targeted tax benefits. This means that you can’t do cost segregation on the existing property because it won’t increase depreciation deductions for periods before applying this strategy. However, suppose one of those conditions is not met, as in the case of a renovation (where you will increase depreciation deductions for periods before the tax year in which cost segregation begins). In that case, it might be appropriate to apply cost segregation to that project.
How does Cost Segregation work?
First, determine which items in your project can be cost segregation accelerated. Then identify all the components (both interior and exterior) and assign them to one or more of the separate five-building component asset classes. Finally, calculate depreciation for each element by multiplying its cost basis by the scheduled depreciation percentage for that class.
Cost benefits and drawbacks of using this method for tax purposes
There are several benefits to cost segregation, but the main advantage is paying less in taxes. This is because assets like cabinetry and built-in appliances can be depreciated over five years (rather than 27.5 or 39 years). Not only does this lower your yearly property taxes, but it also reduces your income tax liability. However, it does not lower your overall tax liability as a deduction with a large mortgage payment. Cost segregation can significantly reduce the time it takes for an investor to recoup their investments and start seeing profits from those investments.
Another benefit is that you will see a larger depreciation deduction if you use the cost segregation method rather than the standard method for tax purposes. This is because the cost segregation method reclassifies personal property and reclassifies specific structural components that would usually be classified as personal property under the typical 27.5-year life to which they are subject to ordinary tax depreciation rules.
Is cost segregation better than a standard study?
A cost segregation study is the only way to prove and protect your investment with 100 percent certainty. A typical building’s life can be divided into three-time frames:
- Site work and infrastructure
- The shell of the building (interior partitions, exterior concrete wall panels, etc.)
- Tenant improvements
- The cost segregation study breaks down each time frame by year, allowing for a more accurate depreciation deduction.
A typical study will only show the costs associated with the shell or construction and depreciate those components over 27.5 years. This allows you to claim a portion of your money back, but it only considers a part of your structure. The cost segregation study will identify all components that have been reclassified from real property to personal property and reveals the benefits of all the different accelerated depreciation schedules, allowing you to take a larger deduction in less time.
How is cost segregation different from a property audit/property tax appeal?
Many people confuse a cost segregation study with a property tax appeal. A cost segregation study solely focuses on allocating assets between personal and real property to increase depreciation expense. The appeal process focuses on an assessment ratio study that, among other things, looks at the level of rental income—a successful appeal results in a lower tax rate for your property.
Cost segregation delivers additional depreciation deductions, while a property tax appeal reduces the tax rate applied to the assessed value of commercial properties.
Can cost segregation reduce assessments?
Many states have laws that require sales similar to yours to be assessed at a certain percentage. Cost segregation delivers additional depreciation deductions, while a property tax appeal tries to achieve an assessment ratio study that results in a lower tax rate applied to the assessed value of commercial properties.
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