Did you know you can do cost segregation on virtually any property? Cost segregation identifies assets and costs within a property in order to accelerate depreciation. In return, this generates additional cash flow for the real estate investor, in the earlier years of ownership.
Benefits of cost segregation for property owners
Cost segregation is an excellent tax strategy that helps real estate investors determine which pieces of their property can be on the fast track to depreciation (for example, 5, 7, or 15 years), instead of applying a typical 39 years for non-residential commercial properties, or 27.5 years for commercial residential properties.
By allowing accelerated depreciation on certain assets, those assets can be written off more rapidly, thus lowering upfront tax liability. Property owners can take advantage of the time value of money (also known as TVM) and place the tax savings into higher-return investments, or reinvest the savings into the same property.
Another benefit of cost segregation is to allow for partial dispositions of portions of the property that are replaced or improved. For example, if a building’s HVAC system requires replacement early in the depreciation cycle, the remaining un-depreciated value of the old HVAC system may be written off as a loss.
Without cost segregation, the old HVAC system would be depreciated along with the rest of the building’s 39-year cycle, because there is no way to assign value to the HVAC system by itself. That is the essence of cost segregation—strategically assigning individual values (cost basis) to assets within the property.
Breakdown of a cost segregation
An engineering cost segregation study is performed on the property, breaking the collective assets into four categories for tax purposes. These will include:
Land: when a property is originally purchased, the value of the land itself has to be determined. Land is never depreciated, so it must be “carved out” of the purchase price to determine the depreciable basis of the property’s improvements.
Land improvements: auxiliary improvements, such as landscaping, roads, and fences, are examples in this category. These components must be extracted from the total property improvements to determine the building’s basis.
Tangible personal property: assets that are not structural components of the building may be considered tangible personal property, and may potentially be depreciated sooner than the building itself. These include items like office furniture, floor coverings (vinyl/carpet), and some electrical components and fixtures.
Buildings: this covers the basic shell of the building—the so-called “structural components.” These components typically remain as 39- or 27.5-year property, but the cost segregation process should quantify individual parts, such as roofing, elevators, and boilers, that may be replaced individually in the future. By quantifying their values up front, their remaining basis can be fully written off in the years they are replaced.
In short, cost segregation can help property owners depreciate certain capital assets more rapidly, either in the beginning, through reclassifying certain components to shorter depreciation lives and an accelerated depreciation schedule, or in the future, through early disposition and replacement of any component.
Brian Lefever serves as senior engineer and vice president of operations with Titan Engineering. He has more than 25 years of experience in civil engineering/heavy civil construction and is the firm’s primary IRS audit specialist for all cost segregation audits.