Introduction
Cost Segregation is the method of re-classifying components and improvements of your residential or commercial building from real property to personal property. This process allows certain building assets to be depreciated on a 5- or 15-year schedule instead of the traditional 27.5-year schedule (for residential buildings) or 39-year schedule (for commercial buildings).
When you do a cost segregation study, typically around 20% of your building’s components can be accelerated into 5- or 15-year property. This greatly reduces your current taxable income, thus increasing your cash flow. On average, you’ll receive tax savings of $40,000-$80,000 per each $1MM in building cost… money you can use now for things like building improvements, paying your property taxes, or even purchasing your next building.
When can a cost segregation study be done?
While a cost segregation study can be completed in the year the building is placed in service (or your improvements have been placed in service), the U.S. tax code allows taxpayers to “catch up” on the depreciation that was not claimed from the first day the property was placed in service without amending prior years’ tax returns. Therefore, a cost segregation study should be considered on any property with a remaining depreciable basis. Some building owners who purchased 7 or even 10 years ago can still benefit from a cost segregation study, especially if they’ve made improvements over the years.
Not all cost segregation studies are created equal.
An engineering-based cost segregation study is the method preferred by the IRS. (And unless you want to take a chance of raising a red flag with Uncle Sam, it would be advised to steer clear of other methods.) Engineering-based cost segregation studies are performed by professional personnel with in-depth knowledge of construction methods, materials, and building components. They perform a detailed analysis to accurately identify the building components and improvements that will be reclassified to take advantage of accelerated depreciation.
What does the cost segregation process look like?
The process usually begins with a free analysis that you can share with your tax professional. If your tax professional likes the tax savings you’ll receive, and you are comfortable with the price of the study (make sure the ROI is excellent), the next step is having photos taken of your building.
Armed with photos of every area of your building, inside and out, as well as other vital information that’s collected, including your cost basis, federal depreciation schedule, blueprints (if you have them), a list of improvements you’ve made, and other items, the engineers and construction specialists get to work, developing your comprehensive cost segregation study.
Within about 3-4 weeks, your study will be completed and sent to you and your tax professional to offset your tax liability come tax time. Remember, only for-profit businesses can benefit from cost segregation.
One final note: be sure that the cost segregation firm you work with offers full audit protection at no additional cost. In the off chance that the IRS has questions about your cost segregation study, you want to be sitting pretty, and fully supported.