How to use a cost segregation study to shorten property depreciation

Normally a building is depreciated for income tax purposes over 39 years. A cost segregation study essentially looks at that building — which can be new construction, an existing building that was purchased, or a large build-out or improvement to an existing building — and analyzes the components in pieces and parts.

“For example, if I bought an office building for $5 million, a cost segregation study says that I didn’t really buy a building for $5 million. Instead, I bought various components, such as carpeting, ceiling tiles, lighting fixtures, etc. that totaled $5 million. So, a cost is assigned to all of those individual items,” says David A. McClain II, CPA, associate director of tax at SS&G.

By breaking out the pieces/parts that typically have shorter lives of five, seven or 15 years, you accelerate the return on your money — your depreciation deductions.

Smart Business spoke with McClain about what property owners need to know about cost segregation studies.

What are the tax benefits of a cost segregation study?

The tax benefits are the accelerated depreciation deduction, which increases your cash flow in the first years of your ownership or the renovation project. As a rough illustration, if you purchase a new building for $5 million, instead of waiting 39 years to get a $5 million deduction, you may get $1 million over five years, $500,000 over seven years, another $1 million over 15 years, and then the rest, which is $2.5 million, you’d get over 39 years. Because of the time value of money, it’s better to get deductions earlier, as opposed to over the full 39 years. Obviously, the amount of the purchase price assigned to these shorter lives will vary building by building.

When should a property owner consider getting a study done?

Any time you have building construction, a purchase or a substantial renovation, it should at least be considered. You’ll need to look at cost versus benefit to ensure the cost of doing a study — a function of the project’s size and availability of documentation — is offset by the benefit. In addition, the longer you wait, the study’s benefit versus what you’ve already taken in deductions is smaller.

With renovations and purchases, many people don’t realize cost segregation studies can be done on buildings where you don’t have the original documentation and/or blueprints. There are IRS-approved methods and software that can estimate costs, even in the absence of actual invoices from original construction.

What’s important to understand about the new repair regulations and how they’ve changed cost segregation studies?

Cost segregation studies have been around for a while, but what’s made them even more important is the issuance of new tangible personal property regulations, also known as repair and maintenance or 263A regulations.

Previously, you could not partially dispose of an asset. If you had an asset and part of it, for whatever reason, went away, you had to wait until you got rid of that entire asset to actually dispose of it.

Some classic examples are a roof or HVAC system. Let’s say you bought a building and had to replace the roof eight years after the purchase. The initial cost allocated to this roof, signed to a 39-year life, might be $200,000. Eight years in, you’ve only depreciated roughly 20 percent the cost. With the new regulations, you would capitalize the cost of the new roof, and go back and write off whatever is left of that old roof — the remaining 21 years or about $120,000. It’s a different timetable, and you’re no longer stuck depreciating two roofs, one of which you don’t own anymore.

Under the new regulations, you’re required to know the allocated costs from day one. You cannot go in on the back end and estimate what the cost would have been.

Who is involved in doing the study, and how much of the owner’s time will it take?

A proper study needs to include a licensed engineer and accountant, as required by the IRS. Someone should physically inspect and review the property — do a walkthrough of the facility, take notes and pictures, etc., which are all incorporated into the study.

Generally, accountants try to minimize the impact to building owners, but you may need to be involved in some conversations and/or help go through older records to pull information. However, the benefit should outweigh any inconvenience now.

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