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What Are Cost Segregation Studies?

what are cost segregation studies

Ask anybody who has been house hunting and they can tell you: the housing market is on fire right now. Despite an initial COVID-19 drop, the market has rebounded thanks to low interest rates, increased demand and limited inventory.

The commercial housing market isn’t quite as strong. While the market is recovering, it hasn’t fully returned to pre-COVID-19 numbers. This could provide an opportunity for investors and businesses to purchase property while building prices are less competitive and interest rates remain low.

Purchasing used office buildings, warehouses or retail buildings  may be a good financial move for some, but before taxpayers move forward with such a big asset purchase, they should consider the tax consequences. While spreading depreciation deductions over 39 years (the standard for most commercial building purchases) might be helpful in some cases, they may be able to accelerate their deductions.

What Is Cost Segregation?

Cost segregation studies are performed to identify personal property and land improvements that have been included in the price of real estate. Typically, an expert will be brought in to evaluate the property.

When purchasing real estate, the  property often comes equipped with personal property and land improvements. This is especially true when purchasing property that has been used by other businesses. Perhaps it’s cubicle walls that were left by the prior tenant, furnishings the prior owner didn’t want to disassemble, warehouse equipment that was too difficult to move, or even landscaping.

A cost segregation study identifies the assets that can be classified as personal property or land improvements, then assigns a portion of the building’s purchase price to those assets. These assets have shorter “lives,” allowing the taxpayer to depreciate a larger amount of the purchase price over a shorter period of time. 

By separating the property’s purchase price into three categories — real estate, personal property and land improvements — taxpayers can accelerate a portion of their property’s purchase price into earlier years. The portion of the purchase price assigned to personal property may even qualify to be fully depreciated in the year they purchase the building using bonus depreciation. However, the property must have originated its use with the purchaser. The costs allocated to land improvements can also be depreciated over a much shorter period. If those costs  remain commingled with the building, they must be recovered over 39 years along with the rest of the building.

Can You Perform a Cost Segregation Study on a Building You Already Own?

Yes, you can. Sometimes cost segregation studies are used when a business makes significant improvements to their building. Studies can be performed during the renovations or immediately after they have been completed to help classify those expenses into the correct asset classes. However, the benefits of implementing a cost segregation study tend to decrease the longer the property has been in service.

What Personal Property Assets Are Commonly Found in a Cost Segregation Analysis?

The following are some of the asset classes professionals will identify when performing a cost segregation study:

MACRS ASSET LIVES

PERSONAL PROPERTY5 Year7 Year15 Year
COMPUTERSX
IT SYSTEMSX
SOUND SYSTEMSX
FURNITUREX
CARPETING
X
LIGHT FIXTURESX
WAREHOUSE EQUIPMENTX
LAND IMPROVEMENTS
LANDSCAPINGX
SIDEWALKSX
MOVEABLE PARTITIONSX
DOCKS
BRIDGESX
FENCESX
FREESTANDING ENCLOSURES FOR WASTE RECEPTACLESX

How Are Cost Segregation Studies Performed?

Each professional will approach a cost segregation study a bit differently, but these are the steps most will take:

Conduct a Feasibility Analysis

Before recommending a cost segregation study, CPAs will evaluate whether the cost segregation study will be fruitful. Even if personal property or improvements would be identifiable during the study, the costs of performing the study may outweigh the benefits taxpayers get from accelerated deductions.

Analyze the Property

In addition to touring the physical property, the professionals involved will look at the paperwork, including:

  • Titles
  • Blueprints
  • Site maps
  • Inspection reports
  • Appraisals
  • Paperwork on prior building upgrades, including:
    • Construction notes
    • Architectural renderings
    • Project costs
    • Contractor costso   Change orders

Finalize the Report

The cost segregation study report will include the methodology used, the assumptions made, a list of property that can be accounted for separately from real estate (along with documentation) and tax law references to support the findings. This report is the final “study” and provides the information needed to prepare depreciation forms and serves as substantiation in the event of an audit.

How Does Qualified Improvement Property Play a Role in Cost Segregation Studies?

When Congress passed the CARES Act in March 2020, they corrected an error from the Tax Cuts and Jobs Act to make the property class known as qualified improvement property (QIP) eligible for bonus depreciation. QIP may include land improvements that would not typically qualify for bonus depreciation, giving taxpayers the opportunity to depreciate it fully in the year the property is placed in service.

QIP is nonresidential real property improvements made after a building is first placed in service. Qualifying improvements must be made to the interior portion of the building. They include items like:

  • Plumbing
  • Ventilation systems
  • Alarm systems
  • Installation or replacement of drywall
  • Interior doors
  • Certain mechanical and electrical work

Qualified Improvement Property does not include certain structural improvements such as escalators, elevators, internal structural improvements, or additions to enlarge the property or building.

To use both cost segregation studies and reap the benefits of QIP, taxpayers would:

  1. Identify property they want to purchase
  2. Perform improvements on their newly acquired building
  3. Perform a cost segregation study
  4. Apply bonus depreciation to personal property and QIP identified in the cost segregation study the year the building is placed in service

When Is the Best Time to Do a Cost Segregation Study?

The best time to pursue a cost segregation study is in the tax year you purchase real estate or undergo major improvements to existing property. While it is permissible to perform look-back studies in the future, amending prior year returns and recalculating depreciation will be more costly and time consuming.

Is Cost Segregation Worth It?

The purpose of cost segregation studies isn’t to eliminate taxes; rather, it is to accelerate tax deductions to the current year. A cost segregation study is helpful because it can:

Improve Cash Flow

Accelerating depreciation deductions will improve a taxpayer’s cash flow over the next year and potentially the next several years.

Optimize the Use of Bonus Depreciation

Bonus depreciation is set to phase out in the next few years. Cost segregation studies allow taxpayers to take advantage of bonus depreciation now while it is available.

Tax YearBonus Depreciation Allowance
2021100%
2022100%
202380%
202460%
202540%
202620%
20270%

Provide Peace of Mind

Some taxpayers may think they can perform these studies internally. While it’s possible, the taxpayer will likely feel more confident defending their stance to the IRS if a CPA performed the calculations for them based on a professional study.

While cost segregation  is not the panacea to all cash flow problems, it may boost cash flow just enough to help businesses afford a new building or pay for much-needed upgrades.

See How a Cost Segregation Study Could Help Your Business Save on Taxes

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