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@example.com or (215) 441-4600.