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Cost Segregation Study Example

7 minute read

When purchasing real property that has many different types of assets on it and attached to it, buyers will want to maximize the use of different federal tax benefits available for these different types of properties. Certain types of property—such as manufacturing equipment, office furniture, and computer equipment—benefit from faster depreciation than a real property asset. However, it may be difficult to easily parse out what property and construction costs are able to benefit from accelerated depreciation, especially when they are included in the total cost of the real estate rather than separated out in the purchase agreement documents. In order to maximize the benefit of accelerated depreciation, purchasers of property should consider completing a cost segregation study. The below discussion and cost segregation study example outlines the benefits and importance of a cost segregation study.

What is a cost segregation study?

A cost segregation study is performed to separate which pieces of property are real property and which are personal property. Cost segregation studies are commonly completed when an asset is first purchased, but can also be completed on property you already own. If a property owner were to buy these pieces of property individually they would be able to use the accelerated depreciation methods, which increases tax deductions early in the asset’s useful life. The cost segregation study does this by clearly delineating what pieces of property and construction costs qualify for the accelerated depreciation and establishing a value for each category of property.

How are cost segregation studies done?

It is often recommended for cost segregation studies to be done experts to substantiate property values and categories. The study will divide out the different types of property and costs, assign a portion of the purchase price to that specific piece of property and its value, then provide a classification to determine what length of depreciation can be utilized. The property and costs are generally divided into three main categories: real estate, land improvements/construction costs, and personal property.

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What tax advantages do cost segregation studies provide?

As a baseline, commercial property can be depreciated over 39 years for federal tax purposes, and taxpayers can depreciate the residential rental property over 27.5 years. However, certain types of assets benefit from accelerated depreciation, commonly over 5-, 7-, or 15-year periods. These shorter periods of depreciation will have a major impact on the owner’s federal tax liability. By allowing a shorter depreciation period on certain types of property, taxpayers can realize a tax savings by lowering their taxable income.e. In short, money saved today is more valuable than money saved in the future, so utilizing accelerated depreciation to the fullest extent can provide property owners with large savings today—rather than in the distant future.

What types of property and costs qualify for shorter depreciation periods?

The following types of property and costs are just some examples of what can utilize shorter depreciation periods:

  • Land improvement costs can utilize a 15-year depreciable life.
  • Personal property generally can utilize either a 5- or 7- year depreciable life, depending on the nature of their use and the nature of the business being conducted on the property.
  • Certain fixtures that have a shorter useful life than the property can utilize a 5- or 7-year period depending on use and nature of the business.

When a cost segregation study is completed on high-value properties, the tax benefits quickly become apparent. The benefits become even more striking for heavy manufacturing or high-tech properties, like research and experimentation facilities or pharmaceutical processing and manufacturing facilities. These types of facilities will have a large amount of equipment and attachments that can utilize the accelerated depreciation periods.

Cost segregation study example*:

Sarah purchases a commercial office building for $10,000,000. The land is not depreciable, and Sarah determines that the land is worth $1,000,000. Sarah then determines that the building is worth $9,000,000.

If Sarah elects to depreciate the building over the standard 39-year period, the depreciation allowed per year is $230,769. Assuming a 37% tax rate, Sarah saves $85,385 per year using the 39-year depreciation period.

Instead of using the 39-year period for the entire property’s depreciation, assume that Sarah completes a cost segregation study and, as a result, provides the following:

  • $500,000 of land improvements that can utilize a 15-year accelerated depreciation period.
  • $500,000 of interior fixtures that can utilize a 5-year accelerated depreciation period.
  • Remaining $8,000,000 is assigned as the property's value utilizing a 39-year depreciation period.

Based on cost segregation study findings, Sarah could utilize the following annual depreciation amounts:

  • Building: $8,000,000 / 39 years = $205,128 depreciation.
  • 15-year land improvements: $500,000 / 15 years = $33,333 depreciation.
  • 5-year interior fixtures: $500,000 / 5 years = $100,000 depreciation.

The total depreciation expense for the first year now totals $338,461 and would provide $125,230 in tax savings for the year. Because of the cost segregation study, the tax savings increased by $39,845 compared to just utilizing the 39-year depreciation period for the entire property value.

*Note that this example does not consider any potential bonus depreciation that may be available under the Federal tax code. Property owners should discuss potential bonus depreciation available with their tax advisors and tax counsel.

Conclusion

As the above example shows, a cost segregation study can provide property owners and prospective purchasers of property with significant tax savings. To learn how to save even more on taxes, request a demo of Corvee tax planning software demo!

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