When you purchase office supplies
and other consumable items for
your business, your tax reward is immediate. You can take deductions that
year and recapture some of the cash you
spent in the form of tax savings. But real
estate is a different story. The IRS sets a
27.5- or 39-year depreciation period on
“real property,” such as buildings.
“Cash flow goes out the door to purchase that property, or you have to borrow to acquire that real estate,” says
Susan P. Stutzman, a director in the Tax
Strategies Group at Kreischer Miller,
Horsham, Pa. “That’s cash you can’t use
to run your business.”
A cost segregation study can identify
assets associated with that real property
that can be depreciated much faster. For
example, certain lighting, HVAC, and other
related electrical wiring and equipment can
be segregated and depreciated at five,
seven or 15 years.
“The cash flow from the accelerated
tax savings offsets some of the pain of
that cash outflow to acquire the real
estate,” she says.
Here, Stutzman discussed with Smart
Business how cost segregation studies
work and why they benefit business
owners with real property valued at $1
million or more.
What is cost segregation, and who can benefit from this tax-deferral strategy?
Cost segregation is the process of evaluating the components of real property and
determining whether there are assets that
can be depreciated at a faster rate. Think of
all of the fixtures and infrastructure your
building contains. For example, if you are a
manufacturer, you have equipment. Your
building contains wiring to support that
equipment. Based on IRS guidelines, that
wiring can be segregated from the real
property and depreciated over five or
seven years. By doing this, business owners can depreciate portions of their real
estate investments much faster than the
standard depreciation period of 39 years. A
cost segregation study benefits anyone
who has built or acquired real estate for
commercial use.
What short- and long-term benefits can a
business owner realize?
By depreciating a portion of the investment over a five-, seven- or 15-year period as
opposed to 39 years, you generate more
cash flow upfront for the business through
tax savings. The long-term savings is the
time value of the money you generate from
earlier tax deductions. By ‘earning back’
more money early on, you can put that cash
toward loan payments or reinvest in the
business. Without a cost segregation study,
real estate will be depreciated pro rata over
39 years. Your deduction will trickle in over
that near four-decade time period. If your
commercial real estate is worth $1 million
or more, the return on an investment in a
cost segregation study may be significant.
What steps are necessary for a business
owner to take advantage of a cost segregation
tax-deferral strategy?
Your accountant will work with an engineer, and together they will collect information to determine assets that can be
reclassified. Based on a preliminary analysis, the accountant will provide an estimate
of what percentage of the real estate can be
depreciated faster. You’ll get an estimate of
your potential savings over the short and
long term.
The savings you can realize depends on
the facility. For instance, manufacturing
facilities generally have a much higher percentage of assets to be reclassified than a
parking garage. The initial analysis will
shed light on this.
Finally, your accountant will compare
these savings to the proposed fee for the
full-blown cost segregation study. If your
savings outweigh the fee, the accountant
will advise going forward with the process.
The actual cost segregation study involves
reviewing blueprints and performing site
visits. In most cases, a cost segregation
study is a win-win.
Do you have to take action immediately after
acquiring commercial real estate? When is it
too late?
It’s not unusual for business owners to
own a property for several years before
realizing they can take advantage of faster
depreciation if they reclassify certain
assets. A cost segregation study can be performed on real property in any given year,
although the earlier it is identified, the higher the savings. Those deductions can be
recaptured and claimed on your next tax
return. You’ll see a large cash in-flow that
year because all catch-up deductions are
taken at one time. It’s important to know
that if you decide to reclassify certain
assets, your accountant will not have to
amend prior tax returns. Also, you do not
need prior approval from the IRS to change
your method of accounting to take advantage of these reclassified asset deductions.
As soon as you are aware that you have
an opportunity to reclassify portions of
your real property, contact your accountant for a cost segregation study. The pay-back for knowing about this tax-deferral
strategy is a healthier cash flow and the
leverage to pay back loans faster and rein-vest in your business.
SUSAN P. STUTZMAN is a director in the Tax Strategies Group at Kreischer Miller, Horsham, Pa. Reach her at [email protected]
or (215) 441-4600.
