March 17, 2020

Cost Segregation Studies - Understanding the Benefits

Written by JHM

At JHM, we are currently seeing a tremendous volume of commercial construction and real estate investment. This trend is providing jobs and tremendous economic benefit to our local region. We certainly hope it continues well into the future. The timing seems perfect to remind building owners about the potential benefits of cost segregation studies.

Cost segregation studies are approved by the IRS and provide for an engineering study of your commercial property to separate the personal property cost elements from the total building cost. By doing this, the owner is allowed to take short-life depreciation deductions, as opposed to being limited to normal building depreciable lives, which can be as long as 39 years for nonresidential property. The benefits can be magnified due to currently attractive depreciation laws that allow one-year write-offs for personal property in many cases. Commercial building owners can take 100% bonus depreciation for assets placed in service through January 1, 2023. Doing this can provide important cash flow through early-year tax savings.

The study itself involves a specialist analyzing the building cost information to identify property that meets IRS personal property definitions. Examples may include special-purpose or decorative lighting, flooring and wall coverings, certain wiring and networking, cabinetry, plumbing fixtures, office equipment and other items. The specialist prepares a report that is used by the CPA firm in preparing the tax returns. This study can be performed all the way up until the extended due date of the tax return.

If the study is performed in the year of construction, the depreciation in year one will be based on the study. If performed on a building already in use, a special “catch-up” provision, or Section 481(a) adjustment, is applied on the next tax filing. Depending on individual circumstances, this catch-up benefit can be substantial. The catch-up adjustment brings accelerated depreciation benefits from prior years into the current year as a single deduction. The result can be a large reduction of current year tax liability.

What types of property qualify?

Any property held for a business purpose is subject to depreciation and may benefit from a review. This includes BOTH new and existing properties. Generally speaking, case studies we’ve seen at JHM lead us to believe that it makes the most sense for buildings with a cost in excess of around $500-600K. The more interior finishes, the better. Smaller buildings could make sense if they are part of a larger portfolio of buildings held by one taxpayer.

Commonly overlooked opportunities may include:

  • Hotels
  • Office Buildings
  • Manufacturing Facilities
  • Assisted Living Facilities
  • Multifamily Units
  • Retail Units

What does the IRS say about all this?

The IRS sees cost segregation as a legitimate method for determining the useful life of building components. This has been upheld in various court decisions and IRS publications. The IRS came out with an Audit Guide that not only confirms this position, but also lists a number of relevant court cases.

However, not just anyone can perform the study. The IRS wants to see someone with knowledge of both the construction process and the complicated tax laws surrounding depreciable property. The IRS position is that the specialist’s experience may have a bearing on the accuracy of the study. Furthermore, a study performed by a less qualified company can actually leave money on the table, by often not segregating all the personal property.

What role does JHM play?

At JHM, we do not perform the actual study, but we have relationships with experienced companies that have excellent track records in this practice area. More importantly, we can help you on the front-end to decide if it even makes sense with your personal tax situation.

Here are some situations where cost segregation wouldn’t make sense:

  • If you plan to flip the property in the near future, or
  • If the building owner already has significant losses for tax purposes

The specialist will charge a fee for the study, so a nice ROI needs to exist in each situation. We can help with this determination, after the segregation specialist provides a fee proposal and outline of your expected benefit free of charge.

Finally, when the study is complete, JHM can execute the benefits to highest advantage on the building owner’s tax return. For instance, in some cases it may make sense to take the personal property deductions over their new shorter lives, as opposed to taking them all in the first year.

At JHM Certified Public Accountants, we can assist in your individual evaluation of this potential tax benefit. We will then work in conjunction with the outside specialist to maximize property segregation, and execute the results on tax filings to the highest benefit. Importantly, we receive no benefits or kickbacks from, and have no alliances with, the segregation specialists. Therefore, we will quickly tell you if it doesn’t make sense to consider. Our interest in this area lies solely in trying to provide the best benefit to our clients. Please give us a call if you’d like to discuss this or other potential tax strategies further.