Accelerating depreciation through cost segregation frees capital and drives growth
As the economy gains a stronger foothold and real estate rebounds, new construction, acquisitions and renovations are occurring with greater frequency, allowing owners to take advantage of tax incentives like cost segregation. In late 2013, the IRS released the final new tangible property regulations, which allow for a more detailed study that, in many cases, significantly enhances the benefits of cost segregation. Tax deductions, credits and other government incentives are designed to create opportunities for companies to generate cash that can stimulate further growth.
Cost segregation is a federal tax depreciation strategy that allows a company to increase the short-term depreciation expense deduction by accelerating depreciation on certain components of a newly built or acquired property or property that has been recently renovated. Simply put, cost segregation is an interest-free loan gained by frontloading depreciation rather than spreading it over the full 27.5 or 39-year life of a property.
For a company that holds a building for at least seven years, cost segregation is a viable and often lucrative opportunity. A typical commercial building depreciates over 39 years, while multifamily structures such as apartments or nursing homes depreciate over 27.5 years. However, a cost segregation study identifies components of a building that can be allocated into shorter class lives and depreciated faster. These tax lives are dictated by the modified accelerated cost recovery system (MACRS) implemented by the IRS in the mid-1980s. In the case of commercial buildings the most common classes are 5, 7 and 15 years.
The SourceHOV|Tax approach to cost segregation
The SourceHOV|Tax in-house cost segregation team is comprised of architects, professional engineers, CPAs, MBAs and LEED certified professionals dedicated solely to cost segregation. We believe experience is critical to maximizing the benefits of cost segregation, and the majority of our team has spent between 8 and 16 years managing cost segregation projects. Even our least experienced member has conducted more studies than many who manage projects at large firms. Our top three professionals are involved in every project we’re engaged to perform and often conduct the site visits themselves. And, with rare exception we always conduct a site visit. The IRS expects it, and we believe it is the only way to accurately assess a property.
When conducting a cost segregation study, we focus on two primary areas of a building – §1245 tangible personal property and land improvements and §1250 real property. Land improvements include components outside the exterior walls of a building that are attached to the ground like landscaping, paving and certain lighting. Land improvements typically fall into a 15-year class life, however there are exceptions such as incoming and outgoing utilities that are essential to a functioning building.
There are three additional types of 15-year property called real property – qualified leasehold improvement property, qualified restaurant improvement property and qualified retail improvement property. For specific years, temporary additions to the tax code pertaining to real property, allow parts of the actual building structure to be classified as 15-year property.
On the inside of a building, we identify §1245 tangible personal property. Section 1245 property can fall into either a 5 or 7-year class life depending on how it is used and the activity class of the business. While there are a number of nuances as to what can qualify as §1245 property, in general components that are easily removable and considered to be reusable will qualify as will machinery and equipment that is critical to the business but is not part of the building. In addition, the electrical, mechanical and plumbing needed to service such machinery and equipment qualifies since it is neither part of the building nor is it easily repurposed.
When originally conceived, class lives were based on the useful life of an asset. However, today it is the activity class that determines the class life, and those vary from business to business. For example, a manufacturer must depreciate carpeting over 7 years while an auto dealer can depreciate it over 5 years simply because dealerships fall into a different activity class.
Key benefits of cost segregation
A cost segregation study results in properly identified and depreciated building components, allowing a company to leverage the depreciation expense deduction during the early years of owning a building. And, in many years, bonus depreciation applies, further increasing the benefits. For companies that own or have renovated a building within the past 15 years, cost segregation is an advantageous strategy to generate cash that can be reinvested into the business.