Many executives are curious about cost segregation studies, but are unsure how they work, or even if their business would benefit from one.
Basically, a cost segregation study looks at specific components of your business’s facilities to find which components can be separated out and depreciated over shorter time periods, therefore speeding up the related tax deductions. The true value of a cost segregation study is realized by looking at the time value of those tax deductions being able to take the related tax deductions sooner provides more value for the taxpayer.
“The benefit of a cost segregation study is that you would get more deductions in the first five, seven or 15 years than you would if you didn’t do one,” says David R. Walter, CPA, MBA, a manager with Skoda Minotti. “Without one, you would get more deductions between years 15 to 39. When you’re looking at value of money over time, you’ve actually lost out without the cost segregation study.”
Smart Business spoke with Walter about the frequently asked questions he receives about cost segregation studies.
What does a cost segregation study entail?
A cost segregation study is the review of a building by a qualified individual (engineer) to identify items qualifying for quicker depreciation. These studies are a combination of reviewing the blueprints and the cost report (for constructed buildings) or appraisal report (for purchased buildings) to evidence the building make-up, and visiting the actual building to see if there are any other items that can be split out even though it’s not clear in the source documents.
How is the tax deduction calculated?
A building is depreciated using the straight-line method for 27.5 years (residential) or 39 years (commercial). In most cases, the cost of the building is made up of the total cost to construct or purchase the building. This study can separate out parts that can be depreciated over five, seven or 15 years, essentially speeding up tax deductions.
For example, let’s say the total cost of a commercial building was $975,000. Without a cost segregation study the annual depreciation expense would be $25,000 ($975,000/39). If the study determines that $195,000 of the building’s total cost is land improvements, which can be depreciated over 15 years, the annual deduction for the first 15 years increases to $33,000 (($975,000-$195,000)/39 + ($195,000/15)).
Even though the taxpayer will get the same amount of deductions over the life of the building either way, speeding up that depreciation on those specific assets speeds up tax deductions.