If you own real estate, a cost segregation study is one of the best tools to help you reduce taxes and improve cash flow. Although a cost segregation study will not provide additional tax deductions, it will enable the taxpayer to accelerate a portion of the depreciation on the building, says David R. Walter, CPA, MBA, tax manager at Skoda Minotti.
“Cost segregation is the process of breaking out a portion of a building’s cost that can be depreciated quicker than the standard life of 39 years,” Walter says.
Smart Business spoke with Walter about the benefits of performing a cost segregation study and how doing so can help keep money in your business.
Where should a property owner start when considering a cost segregation study?
The purchase or construction of a building is the starting point for any cost segregation study. Any building is eligible, but the owner must determine if it is cost beneficial to perform a study. Any cost segregation study should start with a cost-free estimate to quantify the potential tax savings from doing the study. These estimates usually do not take a large investment of time, as only a few items of basic information are needed.
How can an owner determine if a cost segregation study is worth the investment?
Most firms that provide cost segregation studies provide a cost-free analysis of the potential tax savings. This analysis gives you a conservative estimate of how much could be saved, the net present value of those savings, and the fee for conducting the study. This allows you to compare the net present value of what you could save, versus what you’re going to pay for the study, allowing you to make an educated decision.
At worst, you’ve invested half an hour to pull together information to get an estimate and see whether it makes sense.
What is the minimum building value at which a study is worth the investment?
There is no true value that answers this question. It depends on the size and type of building. If you’re talking about a traditional warehouse, which is essentially just four walls, $500,000 would be a general rule of thumb. But if you have a specialized facility, that rule of thumb could drop down to $200,000 or $300,000. I tell clients that while these may be general guidelines, because an estimate is free, any building owner should get an estimate to determine if a cost segregation study makes sense.
When should a study be performed?
Ideally in your first year of ownership. The sooner you break down the costs and depreciate them over those shorter depreciation periods, the sooner that you’re going to reap those benefits.
However, it is still worth doing a study even if the building was purchased/constructed in a prior year. With a cost segregation study, you can go back and determine the amount of depreciation that should have been deducted if a study was done at the beginning, and compare that to what actually was deducted. The current IRS rules allow you to deduct, in the year of the study, the difference in depreciation up through that year, thus getting the taxpayer caught up all in one year.
The value of a study is based on the time value of money saved. If you buy a building today, the sooner you get the study completed, the more beneficial it will be.
Are there benefits of performing a study beyond accelerating depreciation?
There may be some potential benefit on the insurance side. With a cost segregation study, you’re detailing the cost basis of the building. With this detailed cost basis, the replacement cost of the property may be better determined, which could lower the insurance premiums on the building.
Is this something building owners can do on their own?
No. The IRS has stated that an engineering-based approach must be used to substantiate the cost breakdown. If the segregation of costs is not supported by an engineer’s report, it will not stand up under audit of the IRS. Although that means investing in a professional, the cost is typically worthwhile when compared to the savings you will realize.
Why should owners pay for a study when they still get those deductions over time without one?
It’s all about timing and the ability to push those deductions into earlier years. From a time value of money standpoint, the sooner a deduction can be taken, the more valuable it is.
If you look at a $1 million building, either way, you’re going to deduct that cost over 39 years, but by moving 25 percent of that million-dollar depreciation into earlier years, for example, you are decreasing your taxes in earlier years and getting that money back in your business sooner.
Everyone needs cash, and one of the best ways to get it is to reduce taxes in earlier years. Most tax planning strategies are based on the deferral of taxes, and that’s what you’re getting here. You’re deferring the taxes for a number of years and using that cash to grow the business.
What role should your CPA play in the process?
As much as this is an engineering approach, there is also a tax side. Your cost segregation study may produce a deduction, but you want to make sure you are working with a knowledgeable CPA to figure out how those tax deductions are going to play into your tax situation.
You don’t want to be in a position where you have paid for the study and then later find out that because of your situation, the deduction didn’t quite work out.
David R. Walter, CPA, MBA, is a tax manager at Skoda Minotti. Reach him at (440) 449-6800 or firstname.lastname@example.org