Cost segregation studies can result in significant tax savings for a property owner, says David Hopkins, a Certified Public Accountant at SS&G Financial Services, Inc. in Akron. Since property can be divided into its component parts, cost segregation studies are about taking advantage of IRS rules to classify assets and to then properly compute depreciation for each asset.
Smart Business spoke with Hopkins about the rules of cost segregation studies.
What is a cost segregation study?
A cost segregation study generally reallocates the costs associated with construction projects from real property to tangible personal property. This reallocation often allows for a tax savings because personal property has a shorter lifespan and thus can be depreciated over a shorter time period and is eligible for accelerated depreciation, compared to real property that’s generally depreciated over 39 years. Such a study may be a useful tax-savings tool for the owner of a building or for a tenant who has made leasehold improvements to a property. Since cost segregation studies are complicated and carefully scrutinized by the IRS, it’s very important that they’re performed by experienced professionals who can understand blueprints and construction specifications. There are CPAs that specialize in conducting these studies.
What in a building could be reclassified as personal property?
The list is long and varied. For the purpose of a cost segregation study, things such as landscaping, parking lots or sidewalks, carpeting and wallpaper could all be reclassified as personal property. There are also specific items for different building types, such as lead walls in a dentist’s office or power lines dedicated to machinery and equipment in a factory.
What are the financial benefits?
Cost segregation studies are conducted with the goal of increasing cash flow via tax savings. If you own a $4 million building that’s being depreciated over 39 years, you would have an annual depreciation deduction of about $100,000. So, over seven years, you’d see a depreciation deduction of about $700,000. Implementing a cost segregation study that now yields $1,575,000 worth of depreciation deductions over a seven-year period gives you $875,000 of additional deductions. Assuming a combined effective tax rate of 40 percent, this represents a tax savings of $350,000 over the first seven years.
Who should consider having a cost segregation study performed?
Generally, cost segregations can be performed on property that was acquired or built after 1987. It should be considered by an owner or owners of a building when there has been a change in ownership or if there have been major improvements or an addition made to the property. New construction projects are ideal candidates for cost segregation studies because actual cost data and blueprints tend to be readily available.
What are the steps involved and how long does it take?
A CPA will need to determine the purpose and function of all property. An analysis of all construction and engineering drawings and specifications will be completed, and an on-site inspection of the property will be done. A report will be provided to the owner upon completion that explains the allocation of assets between real and personal property and the class life of the personal property, and it will also include a summary of the tax savings and additional depreciation deductions to be claimed on the tax return. It takes about two to six weeks to complete a study, depending on the complexity of structure.
If I have a cost segregation study completed, will I have to amend my prior tax returns?
No, this is certainly one of the benefits. The IRS allows you to take the cumulative adjustment on your next return. The mechanism would be a change in accounting method filed with the IRS. This change is automatic and requires no user fee. This permits the taxpayer to use cumulative catch-up depreciation in the current year for a building that has been in service for a few years. For instance, in the previous example, if the building had been in service for seven years, the catch-up depreciation for the owner would be equal to $875,000.
Is a cost segregation study advantageous to everyone?
Cost segregations are complex and there are many situations where it’s clearly not advantageous. You have to evaluate your particular situation. For instance, if you’re contemplating selling the building soon, you’d be out professional fees and would-n’t have the chance to reap the tax savings. Also, if you’ve taken a lot of losses with no ability to take additional losses, it isn’t worth pursing a cost segregation study. Many passive investors in real estate will also fail to see a benefit if the cost segregation generates an overall tax loss for the business entity.
DAVID HOPKINS is a Certified Public Accountant at SS&G Financial Services, Inc. Reach him at (330) 668-9696.