Viewpoints

Finding Money In The Walls, Carpets and Sewers of Commercial Buildings and Apartments

Philip A. Mann

Originally Published In:
BUSINESS FIRST
May 2005
Author: Philip A. Mann, CPA

Recent tax litigation and subsequent IRS pronouncements pave the way for real estate owners to realize significant tax benefits associated with depreciation of real property. Many real estate owners overlook a mechanism called  a Cost Segregation Study and pay more income taxes than required by the IRS.  Less money going to the IRS, means more money in your pocket!

A Cost Segregation Study determines the proper asset classification of constructed or purchased real estate. Having a Cost Segregation Study performed allows a taxpayer to accelerate depreciation deductions, reduce income taxes, and increase cash flow. As a matter of fact, the acceleration of depreciation deductions can result in tax savings as much as 10%-30% of the total cost of the real estate. If you own a $3 million building, wouldn’t it be terrific to put $150,000 to $200,000 in your pocket, rather than give it to the IRS?

What is a Cost Segregation Study?

The objective of a Cost Segregation Study is to properly classify building costs into the correct asset categories for income tax depreciation purposes.

The IRS generally classifies assets into 3 major categories:  real property that is generally depreciated over 39 or 27.5 years; land improvements, that can be written off over 15 years, and personal property, that is generally written off over 5 or 7 years. It is relatively easy to identify, and properly depreciate, items such as office furniture and equipment but classifying other building components to land improvements and personal property is not so obvious.
 
Many building owners do not realize that a significant portion of their construction, or acquisition costs, can meet the requirements to be classified as an asset category other than “building”. For example, removable decorative interior ornamentation, millwork, finish carpentry, moveable partitions, counters, cabinets, emergency power generators, decorative lighting and even certain types of HVAC units can be depreciated over five to seven years. Even land improvements like storm sewers, sanitary sewers, paving, curbing and landscaping qualify for accelerated depreciation.

Any building purchased or constructed since 1987 is eligible to have a study completed. This also applies to any building addition or renovation and tenant build-outs

When Should a Cost Segregation Study be Performed?

A Cost Segregation Study can be performed at any time a taxpayer owns a building as long as the costs were incurred subsequent to 1986. The great news for taxpayers that haven’t completed a study is that the IRS allows a taxpayer to go back as far as 1987 to reclassify personal property and land improvement items that have been incorrectly depreciated.  This change in depreciable lives is prospective and no amended returns are required. Any missed depreciation from prior years can be taken in one tax year when a Cost Segregation Study is completed. 

For example, a taxpayer purchases an office building in 2000 for $8 million and depreciates the $8 million over 39 years before completing a Cost Segregation Study in 2005. If the study allocates $2 million of the original cost of the building to 7-year personal property and 15-year land improvements, approximately $1 million in missed depreciation deductions may be claimed on the taxpayer’s 2005 income tax return. At a 40% combined federal and state tax, this results in a $400,000 decrease in income taxes and corresponding increase in cash flow.

A Final Word of Caution

Engineering firms typically perform cost Segregation Studies, as the IRS generally doesn’t consider an accountant qualified to complete a study.

In fact, the IRS has issued guidelines as to what constitutes a qualified Cost Segregation Study. The one hundred forty-five page guide details the necessary work that must be completed before they will allow a taxpayer to reclassify building costs to asset classes with shorter write-off periods. Since Cost Segregation Studies involve a combination of engineering, accounting and knowledge of tax law, it is incumbent upon building owners to engage a qualified firm to perform the studies.

Disclaimer: The Bonadio Group provides the information in Viewpoints for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in Viewpoints are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.