Cost segregation studies are an effective component of any cash management strategy for a business that owns buildings or other depreciable real property for business use. The strategy involves the deferral of income tax liabilities to later years through the identification of property having a shorter cost recovery period for federal income taxes, which even the IRS acknowledges as an appropriate deferral method.
Smart Business spoke with Walter McGrail, senior manager at Cendrowski Corporate Advisors LLC about using cost segregation.
Why are cost segregation studies effective?
The benefit is the ‘present value savings’ attributable to the deferral of federal and state income taxes. The actual savings is the reduction in current tax payments now, with resulting increases in taxes payable in subsequent periods, i.e., the ‘time value of money’ attributable to tax deferral. As with any treasury cash management program, a property owner’s cost of capital is typically the appropriate discount rate to measure the ‘present value savings’ of deferring cash charges for income taxes.
How does it work?
First, cost segregation studies identify categories of costs that have a shorter cost recovery period for income tax purposes. Buildings typically have a depreciable life of either 27 or 39 years, while the depreciable lives of furniture and fixtures ranges from five to seven years. Though the total amount of cost recovered is the same regardless of the recovery period, the shorter it is, the sooner the resulting tax savings occurs.
Second, shorter life property generally qualifies for accelerated depreciation methods. Buildings are depreciated under the straight line method, which results in the same depreciation expense during each year the building is owned. Shorter recovery life property identified in a cost segregation study may be depreciated under accelerated cost recovery methods. For example, depreciating property with a five year life using accelerated depreciation on the same five year property results in more than 70 percent of the cost being depreciated during the first three-year period. There are also new Treasury regulations that permit immediate deduction of qualified repair costs. The professional conducting the cost segregation study will be able to apply the new expensing regulations, as well. The tax savings occurs for both federal and state income taxes. Current federal corporate income tax rates are 35 percent and states’ are typically are around 5 percent.
How is a cost segregation study conducted?
Studies must be properly conducted to withstand IRS scrutiny, which requires not only professionals trained in the proper classification of assets for federal depreciation purposes but also personnel with engineering and construction experience to properly classify the components of a structure. Key to a successful audit defense are documentation of findings and expert personnel.
What businesses might benefit from this?
Cost segregation studies can be conducted on new construction, rehabs, recently purchased properties, or even properties held for a period of years. For newly constructed property, and to some extent rehabilitated properties, shorter life depreciable property may qualify for bonus depreciation. Bonus depreciation rules permit a first year depreciation deduction equal to 50 percent of the cost of identified qualifying property. Bonus depreciation and more favorable capital expenditure expensing elections will expire after 2012.
What is the time frame to conduct a study?
In order to make a claim for the 2012 calendar year, the study must be conducted before the extended due date of the 2012 returns, typically Sept. 15, 2013. Sufficient time should also be permitted to coordinate the findings of the study with the business’s preparation of its 2012 income tax returns. For properties owned prior to 2012, the IRS has provided a relatively straightforward means to claim the resulting difference in depreciation expense before and after the study is conducted.
Walter McGrail is a senior manager at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or firstname.lastname@example.org
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