Businesses that acquire, construct, or substantially improve a building - or did so in previous years - should consider a cost segregation study. These studies combine accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property, allowing you to reduce your tax liability and boost your cash flow by accelerating depreciation deductions. And the potential benefits are now even greater due to enhancements to certain depreciation-related breaks under the Tax Cuts and Jobs Act (TCJA).
The IRS generally allows you to depreciate commercial buildings over 39 years (27.5 years for residential property). Most times, you'll depreciate a building's structural components - such as walls, windows, HVAC systems, elevators, plumbing, and wiring - along with the building. Personal property - such as equipment, machinery, furniture, and fixtures - is eligible for accelerated depreciation, usually over 5 or 7 years. And land improvements - fences, outdoor lighting, and parking lots for example- are depreciable over 15 years.
Too often, businesses allocate all or most of a building's acquisition or construction costs to real property, overlooking opportunities to allocate costs to shorter-lived personal property or land improvements. In some cases - computers or furniture, for instance, the distinction between real and person property is obvious. But the distinction is not always that clear. For example, items that appear to be part of a building, such as removable wall and floor coverings, removable partitions, awnings, window treatments, signs, and decorative lighting, may in fact qualify as personal property.
In addition, certain items that otherwise would, by default, be treated as real property may qualify as personal property if they serve more of a business function than a structural purpose. This might include items such as reinforced flooring to support heavy manufacturing equipment, electrical or plumbing installations required to operate specialized equipment, or dedicated cooling systems for data processing rooms.
Although the relative costs and benefits of a cost segregation study depend on your particular facts and circumstances, it can be a valuable investment. For example, let's say you acquire a nonresidential commercial building for $5 million on January 1. If the entire purchase price is allocated to 39-year real property, you're entitled to claim $123,050 (2.461% of $5 million) in depreciation the first year. A cost segregation study may reveal that you can allocate $1 million in costs to 5-year property eligible for accelerated depreciation. Reallocating the purchase price increases your first-year depreciation deductions to $298,440 ($4 million x 2.461%, plus $1 million x 20%).
Impact of the TCJA
Last year's TCJA enhances certain depreciation-related tax breaks, which in turn enhance the benefits of a cost-segregation study. Among other things, the act permanently increased limits on Section 179 expensing. Sec. 179 allows you to immediately deduct the entire cost of qualifying equipment or other fixed assets up to specified thresholds.
The TCJA also expanded 15-year-property treatment to apply to qualified improvement property. Previously this break was limited to qualified leasehold improvement, retail improvement, and restaurant property. And it temporarily increased first-year bonus depreciation to 100% (from 50%).
If your business invested in depreciable buildings or improvements in previous years, it's not too late to take advantage of a cost segregation study. A "look-back" cost segregation study allows you to claim missed deductions back to 1987.
To claim these tax benefits, file Form 3115, "Application for Change in Accounting Method," with the IRS and claim a one time "catch up" deduction on your current year's return. There's no need to amend previous years' returns.
Property and sales tax considerations
You can also use cost segregation studies to support the property tax or sales tax treatment of certain items. For example, you might use the study to document the cost of tax-exempt property. Many states exempt property used in manufacturing, for example.
A word of caution: Certain property may be treated differently for income tax and property tax purposes, and reporting mistakes can lead to double taxation. Suppose your state has a personal property tax and that you reclassify certain building components as personal property for income tax purposes. If you report these items to the state as taxable personal property, but state law treats them as part of the real estate for real property tax purposes, they may end up being taxed as both personal and real property at the state level.
Is it right for you?
Cost segregation studies may yield substantial benefits, but they're not right for every business. To find out whether a study would be worthwhile, let us do an initial evaluation to assess the potential tax savings.