Real estate investors and contractors that acquired, renovated or built a building should consider a cost segregation study to determine if the property qualifies for accelerated depreciation. Qualified assets are reclassified from real property to personal property for federal income tax purposes and have a shorter depreciable tax life.

A 39-year or 27.5-year property could qualify as a five-, seven- or 15-year property. Generally, 20% to 40% of the property can be reclassified as personal property. Flooring, signage, landscaping and parking lots are examples of building components that can be reclassified.

Typically, the building should have been placed in service in the last five years, and the cost of the building, remodel, expansion or build-out should be at least $750,000. A change in accounting method may be required.

The benefits realized from a cost segregation could be considerable under the Tax Cuts and Jobs Act (TCJA). TCJA removed the restriction on taking bonus depreciation on used assets acquired after Sept. 27, 2017, and placed into service prior to Dec. 31, 2017. Personal property acquired as part of a building may qualify for immediate expensing by claiming 100% bonus depreciation.

What is a Cost Segregation Study?

A cost segregation study identifies assets and their associated costs to determine if they qualify for accelerated depreciation. Tangible property regulations allow a cost segregation study to establish the depreciable value for each major component of a building that may be replaced in the future. This includes the roof, HVAC system, doors, windows and bathroom fixtures. A retirement loss or partial disposition is claimed for the depreciable basis remaining on the component.

Bonus Depreciation

Bonus depreciation on new construction increased from 50% to 100% for the first five years of the asset’s life under TCJA. The building must have been placed in service after Sept. 27, 2017, and before Jan. 1, 2023. After 2022, the bonus depreciation percentages for qualified property placed in service decreases to 80% for 2023, 60% for 2024, 40% for 2025 and 20% for 2026. If renovated property was expanded or exterior facades, HVAC systems, elevators, escalators, load bearing walls or other components were added, a cost segregation study should be conducted to determine which, if any, of these assets should be re-classified.

A non-structural asset installed in the interior of a building after it is placed in service is considered a qualified improvement property. This type of asset does not qualify for bonus deprecation and therefore must be classified as a 39-year property.

It is no longer necessary to meet the “first use” test to qualify for bonus depreciation. Eligible assets acquired after Sept- 27, 2017 (subject to limitations), now qualify for bonus depreciation.

Taxpayers have the option to elect out of bonus depreciation for any class of property annually. In addition, for the first taxable year after Sept. 27, 2017, the taxpayer can elect to apply a 50% bonus rate instead of 100%.

Take an Engineering-Based Approach

The IRS recommends taking an engineering-based approach when performing a cost segregation study to comply with regulations. Qualified professionals, such as an engineer and Certified Public Accountant (CPA) with expertise in this area or a person holding the Certified Cost Segregation Professional designation from the American Society of Cost Segregation Professionals should be engaged to conduct a cost segregation study to ensure compliance with all the applicable tax laws. Most professionals will first do a free feasibility study to determine the potential savings and return on investment.

The Bottom Line

Although there are many advantages of conducting a cost segregation study, there are disadvantages as well. Time and money will need to be invested in an engineer, CPA, and other professionals to ensure that the cost segregation study meets the requirements of the IRS. The cost of a cost segregation report can be $10,000 to $25,000. Even so, the tax savings realized could pay for the report.

A cost segregation study can be used to identify other tax saving opportunities. These include the possibility of deducting repairs, retirement and removement costs, as well as if the property qualifies for green building deductions and other tax elections. The property might meet IRS requirements for qualified leasehold improvements, qualified retail improvement property, qualified restaurant property, or qualified improvement property.

Some property owners view this as a risky tax planning strategy. In most cases it is not if the study complies with IRS regulations. Problems arise when property-owners cut corners or attempt to do a cost segregation study themselves.

This article is for informational purposes only and doesn’t constitute professional advice.