Cost Segregation 101
Did you recently purchase, remodel, or build a building? If so, are you confident you are maximizing your depreciation options? Real property often comes with one purchase price for the overall building or land. This creates an issue when it comes time to depreciate the business asset.
Utilizing cost segregation gives your business the ability to identify separate components, opening the door to special depreciation options to recoup your initial investment quicker.
Cost segregation isn’t just limited to businesses that are improving, building, or purchasing property in the current year. In fact, businesses are able to go back and secure additional depreciation options to strategically reduce taxable income.
This makes it important to evaluate the specifics of cost segregation to determine if it’s right for your business.
What is Cost Segregation?
Cost segregation is a tax planning tool that allows businesses to accelerate depreciation for real estate components while deferring federal and state income taxes. Special depreciation options, such as Section 179 and Bonus Depreciation, have limitations on the kind of property that qualifies for accelerated depreciation, specifically excluding real property. According to the IRS, real property includes land and anything built on it or attached.
Bloomberg Tax outlines the general depreciation categories, which include 27.5 years for residential rental property and 39 years for nonresidential real property. However, most personal property holds depreciation periods ranging between 3 and 15 years. Cost segregation looks to identify the components that fall into the personal property categories to qualify for immediate expense deduction.
Even if special depreciation options aren’t available, the general MACRS holding periods are significantly lower compared to including all components with the residential rental property or nonresidential real property categories. This allows businesses to recoup the initial investment costs quicker.
Who Qualifies for Cost Segregation?
Corporations, trusts, partnerships, and individuals who hold real estate investment properties that were built or purchased within the past 15 years qualify. The business would have purchased, built, expanded, or remodeled a residential or nonresidential property to meet the criteria.
Common examples of qualifying types of property include office buildings, rental properties, banks, apartment buildings, golf courses, grocery stores, restaurants, and manufacturing facilities. Personal homes are specifically excluded unless you claim the dwelling as a rental. If you are wondering if your real property qualifies, reach out to a tax professional.
What is a Cost Segregation Study?
A cost segregation study is the process of allocating transaction prices to the individual components of real estate. When you purchase real property or start remodeling an existing building, the overall transaction price generally includes other components besides the building or land. For example, if you purchase an existing office building, there may be furniture located within the building that is classified as Section 1250 property.
The main purpose of a cost segregation study is to properly classify the identifiable components found within the real estate property.
The IRS has different asset categories, which include:
Section 1245 is not truly a separate category when compared to Section 1231. Due to the overlapping, having a cost segregation study conducted by an expert is important. Regardless, a cost segregation study will try and place assets into the Section 1231 and Section 1245 categories to take advantage of special depreciation options.
How Does a Cost Segregation Study Work?
A cost segregation study generally includes a few different steps. It’s imperative that you enlist the help of a professional to complete a cost segregation study since the IRS may require you to submit a copy of the report, especially if you are completing an engineering-based cost segregation study. There are four main steps involved in a cost segregation study including:
This step involves estimating the potential benefits and fees associated with completing the study. If you are completing the study yourself, you won’t have very many fees; however, you should still be analyzing the feasibility. You won’t want to go through the rest of the process if there is a minimal tax benefit.
Once it’s determined that there is a tax benefit, you will need to work with the professional to gather the necessary information. For a building that was purchased, this includes a copy of the appraisal, an assessment of the property condition, a land survey, and closing documents.
For a building that was built or remodeled, you will need to provide the professional with the total project costs, the costs of the general contractor, change order details, invoices from vendors, and construction plans. This is the information that will be used to separate costs.
The next step is one of the most important steps in the entire process. The professional will analyze the property and pull out identifiable segments. To reach their conclusions, the professional will generally complete an on-site visit of the property, examine each of the relevant documents, and make estimates on cost information.
Once the report is completed, you will be able to use this information to take advantage of special depreciation options. In addition, the completed report should be kept on file for as long as you hold the property. This will help support your position in case the IRS inquires about your rationale.
The specifics of what’s included in the cost study will vary depending on the activities of your business.
When Should a Cost Segregation Study Be Completed?
Special depreciation options are available in the year the asset is placed in service. This means that a cost segregation study should be conducted in the year the real property was purchased, remodeled, or built. However, even if you purchased real property in prior years, you can go back and complete a cost segregation study and “catch up” on missed depreciation opportunities without having to go back and amend prior years.
Additionally, Bonus Depreciation is set to begin phasing out over the next few years, making now the right time to perform a cost segregation study to maximize your tax savings potential. The average turnaround time for a cost segregation study is between 30 and 90 days. Keeping the turnaround time in mind is critical to receive your completed study before you need to file the tax returns.
How Do You Claim Cost Segregation?
Cost segregation impacts a few different areas of your tax return. First, you will need to have a cost segregation study to base your depreciation on. Then, you will update your tax return or fixed asset software based on the different components identified. Keep in mind that cost segregation only affects your asset depreciation for tax purposes, not financial purposes.
The actual claiming of Section 179 and general MACRS will be found on Form 4562. This form will flow through to the face of your tax return or wherever you report depreciation. Bonus Depreciation is reported on Schedule K for most businesses. You may also need to provide a schedule that outlines each asset and depreciable base to support your tax position.
If you have a cost segregation study completed, it’s not a bad idea to attach the report to your business return; however, this is optional, depending on your industry. The more information you can provide the IRS and state agencies to substantiate your tax position, the better.
Claiming cost segregation will also result in a book-to-tax adjustment, which is found on Schedule M-1 or M-3 for corporations and partnerships. Sch E taxpayers will not have a book-to-tax difference on the tax return and will only report the tax depreciation.
Are the Cost Segregation Requirements Different for Startups and Existing Businesses?
The process for claiming cost segregation for startups and existing businesses can vary depending on when the real property was placed in service. Startups that are claiming depreciation on property placed in service that year will only need to fill out the corresponding depreciation forms, including Form 4562.
However, businesses that are going back and using cost segregation will need to file Form 3115 Application for Change in Accounting Method. Filing this form eliminates the need to go back and amend prior year tax returns. This form, with the corresponding cost segregation study, will convert the original depreciable base of 27.5 or 39 years into identifiable components. Property that was placed in service after September 27, 2017 can then take advantage of Bonus Depreciation.
What are the Benefits of Using Cost Segregation?
Cost segregation comes with significant tax benefits. Without cost segregation, your business will be limited in the amount of depreciation able to be taken, dragging out the depreciation period to 27.5 or 39 years. This significantly impacts cash flow, with your initial investment unable to be fully recouped for decades. By utilizing cost segregation, you are able to reduce taxable income in the period that the expenses incur, improving cash flow.
Moreover, cost segregation allows you to legally reduce your tax burden, making it one of the most effective tax planning strategies. Businesses that use cost segregation can see a 30% to 40% reduction of their tax liability, depending on how their business is taxed. Furthermore, a cost segregation study allows you to review the different components of your real property, providing transparent insight into operations.
What are the Financial Implications of Cost Segregation?
Cost segregation does not have an impact on your GAAP financial statements. Instead, this adjustment solely affects your tax position, creating a book-to-tax difference that will need to be tracked until the real property is eventually sold.
For example, the entire cost of your real estate transaction, including improvements, will be on your balance sheet as a fixed asset. Under GAAP, the property will be depreciated through straight-line depreciation based on the estimated useful life. However, for tax purposes, a portion of the cost will be immediately depreciated under special depreciation options. This creates a depreciation difference that will need to be accounted for each tax year.
Additionally, when you go to sell the real estate or land, you may have a different adjusted basis for calculating gains and losses. Cost segregation doesn’t eliminate the tax burden associated with real property, but instead defers it until you dispose of the property.
What are the Advantages of Working with a Professional?
Although performing a cost segregation on your own is doable, it opens the door to an increased risk of error. This is why working with a professional is advantageous. In addition, if your business is audited, the IRS may request a copy of the cost segregation study to confirm that assets are being properly depreciated. You want to have this information on file and ready to go in the event of an IRS request or inquiry.
Even though IRS outlines Cost Segregation Audit Techniques, there are no clear-defined rules on how property should be classified. Businesses can follow GAAP and the Tax Code, but there are gray areas involved in cost segregation. The penalties for misclassifying assets can be detrimental, with the IRS potentially nixing your special depreciation claimed, resulting in back taxes and amended returns. Working with a professional can alleviate some of this risk.
Summary
Cost segregation is a powerful tool used to leverage special depreciation options and reduce taxable income. Working with a professional is critical to ensure your business is maximizing results, making it important to reach out to the team at BUSINESS.
BUSINESS has been helping businesses take full advantage of the real property they place in service, regardless of when the purchase, improvement, or remodel took place. For more information, reach out to a team member today.
Sources
Bloomberg Tax. “Property Depreciation Methods: MACRS.” Bloomberg Tax, 23 Aug 2022. https://pro.bloombergtax.com/brief/macrs-depreciation-method/. Accessed 20 Nov 2022.
IRS. “Publication 544 (2021), Sales and Other Dispositions of Assets.” IRS, 17 Feb 2022, https://www.irs.gov/publications/p544#en_US_2021_publink100072575. Accessed 20 Nov 2022.
IRS. “Publication 551 (12/2018), Basis of Assets.” IRS, 13 Dec 2018, https://www.irs.gov/publications/p551. Accessed 20 Nov 2022.
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