Why Cost Segregation
Using cost segregation and reclassification, building owners can shorten the depreciation life of some components of their property. This provides for the reduction and/or deferral of tax liability, quickly freeing liquid cash.
To ensure compliance with federal laws and tax codes, however, you must exercise extreme care when segregating and reclassifying assets. Having a cost segregation study performed by a qualified professional is the first step toward limiting your short-term tax liability.
A Real-World Financial Strategy for Limiting Tax Liability
Under the U.S. tax code, property assets must be depreciated on a 27.5- (residential use properties) or 39-year (commercial use properties) schedule. These extended depreciation lifecycles provide minimal annual tax deductions, even for those properties that have a high-cost basis.
Fortunately, most properties have components that can legally be reclassified as personal property. Once reclassified, you can then depreciate those portions of the assets on a 5-, 7-, or 15-year schedule.
When Does a Cost Segregation Study Make Sense?
Many property owners decide to have an analysis done on their real estate holdings upon learning about the benefits of cost segregation for accelerated depreciation. However, commissioning a study can make good economic sense at almost any stage of the real estate life cycle.
For example, if you are considering the purchase of a property, consider having a cost segregation analysis done as a part of your pre-acquisition due diligence process. This allows you to strategically plan for maximum depreciation. Likewise, if you have a construction, development, or major renovation project on the board, consider adding a cost segregation advisor to your planning and design team. This allows you to tailor the building’s design and specifications for maximum tax benefits.
Determining Whether Cost Segregation Makes Sense for You
Just because your property qualifies for the reclassification of assets does not automatically mean that doing so makes sense. Before investing in a cost segregation study, it makes sense to determine what benefits you could realize.
For example, although properties qualify under the tax code if they have a depreciable cost basis of $300,000 or above, the economic benefits you derive may not sufficiently offset the cost of a detailed segregation study. The higher the cost basis of the property, the more significant your benefits should be. However, if you have made (or plan to make) significant improvements to a less valuable property, you could stand to realize a higher level of benefit.
Because every property is unique, the best way to determine whether undertaking a cost segregation study is to perform a detailed benefits analysis. Before deciding a on study provider, ask whether they can provide you with a benefits analysis. Many of the best cost segregation advisors will provide potential clients with a no-cost, no-obligation benefits analysis.
The Role of the Cost Segregation Study
Cost segregation studies are required by the IRS to provide empirical support for the reclassification of real property-related assets.
To complete the study, cost segregation advisors use an engineering-based analysis approach to determine which property components truly belong in which categories. This involves an extensive review of documents that could include plans, specifications, cost breakdowns, etc., as well as a detailed inspection of the property. The preparer will then create a detailed schedule of property components – so detailed that it can drill as far down as individual electrical outlets, for example – to determine which tax category each component’s costs legitimately belong in.
Although, every property is unique and requires a customized review to determine which components may legally be reclassified. Most property owners can segregate between 20% and 40% of property components for accelerated depreciation.
Required Qualifications for Preparing a Cost Segregation Analysis
Technically, any party can conduct a cost segregation analysis or study. However, if you plan to rely on a study as part of your strategic tax planning, it is important to understand what the IRS will expect, should you get audited.
The bottom line is that the IRS is likely to deny your reclassification of assets unless it is based on a study that was performed by a party that meets the federal government’s standards for experience and expertise in this complex field. In other words, even if a taxpayer’s reclassification of assets is accurate, it will not be acceptable to the IRS if it’s based only on your assumptions. You must provide supporting records in the form of a qualified cost segregation study.