If your clients haven’t considered procuring a cost segregation study on their properties, they may not have claimed the appropriate amount of depreciation. That means they may have missed out on tax deductions in the form of additional depreciation expenses earlier in the life of their properties. They may not know that the studies typically apply to and benefit commercial properties of all types and sizes.
A cost segregation study is the process of identifying and separating personal property that is or has been grouped with real property. To calculate depreciation for federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. A cost segregation study determines the appropriate asset class life for the entire tax basis of the property and allows property owners to reclassify components of and improvements to commercial buildings from real property to personal property. This essentially allows the assets to be depreciated on a five-, seven-, 10- or 15-year class life instead of the traditional 39-year class life of real property (27.5 years for residential rental property).
Weigh the Benefits and Challenges
For many commercial buildings, these assets might be special electrical, lighting, water, plumbing, mechanical, and finish elements. In my experience, 25% to 50% of a building’s total costs can qualify for reclassification into shorter-life assets.
While cost-segregation studies can particularly help to improve cash flow on new construction, they can also provide tax and cash flow benefits for existing structures. In fact, virtually every taxpayer or business entity that owns, constructs, renovates, or acquires a commercial real estate structure should consider these benefits. Most properties are worthwhile prospects for a cost segregation study. In fact, commercial property owners might consider obtaining a study on a building improvement or addition even if the cost basis is as low as $250,000.
These studies can also benefit any type of commercial property. Advantages increase, however, for specialized properties in industries such as manufacturing and medical, which are typically eligible for more five-year deductions. To understand the difference between depreciation with a study versus depreciation without one, consider this example based on studies I’ve completed. Assume the depreciable basis for a new commercial office building is $8 million, and 24% of the cost basis has been identified for allocation to either five- or 15-year property. The costs allocated to shorter asset class lives and eligible for bonus depreciation would be $1.92 million. The current year depreciation with a cost segregation study would be $2,075,900, while the current year depreciation without a cost segregation study would be only $205,129.
Despite the advantages of cost-segregation studies, challenges exist. Engineering-based studies tend to be the most reliable and preferred by the tax court. Yet the Internal Revenue Service (IRS) currently has no set standards for studies, which vary widely in methodology, format, documentation, and reporting. The lack of guidance and the complexity make it crucial to choose a provider who is well versed in the subject, combining an engineering-based approach with the tax knowledge of a certified public accountant (CPA).
With Tax Reform, Studies Have Gained Value
Cost segregation studies became even more valuable when the 2017 Tax Cuts and Jobs Act (TCJA) changed depreciation rules. The TCJA allowed 100% bonus depreciation on qualifying property, or assets with a class life of 20 years or less. It also created one asset class—qualified improvement property (QIP)—by combining three categories: qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. But the tax reform law omitted a recovery period. As a result, QIP, which was intended to be treated as 15-year property, fell into treatment as regular 39-year property for commercial real estate. In addition, the 100% bonus depreciation was disallowed because the property was no longer eligible for bonus depreciation and required businesses to capitalize the improvements as 39-year property.
This unintended consequence was corrected by the CARES Act, enacted in March 2020, which designated QIP as having a 15-year asset class life and therefore being eligible for bonus depreciation. The technical correction is retroactive and takes effect for qualifying property acquired and placed into service beginning Jan. 1, 2018. This could significantly affect real estate deductions on a retroactive basis. Real estate owners should consult a tax adviser about the best way to accelerate their depreciation for the 2018 and 2019 tax years.
Another change resulting from the TCJA involves Section 179, which allows businesses to deduct the full purchase price of certain property in the year of purchase. Property was expanded to include certain building systems and property improvements such as new roofs, HVAC, fire protection, and alarm and security systems.
A cost segregation study identifies all the building’s systems so that the tangible property regulations, or repair regulations, can be properly implemented. The IRS released those regulations in 2013 and 2014 to guide taxpayers in determining whether to capitalize or currently deduct expenditures for acquiring, maintaining or improving tangible property.
The tangible property regulations also introduced the definition for a “unit of property,” which is generally the entire building and its structural components, including the foundation, roof, walls, partitions, floors, windows, ceilings and permanent coverings, such as paneling or tiling. Before building owners can determine whether to capitalize an expenditure, they must understand the unit of property and the building systems, which include HVAC, plumbing, electrical, elevators, escalators, fire protection, security and gas distribution. The expenditure is evaluated to determine if it meets the definition of a restoration; an adaptation to a new or different use; or a betterment or improvement of the building system and unit of property. A cost segregation study will help to identify the costs related to these various building components so that building owners can apply the proper tax treatment.
Consider A Look-Back Study
It’s never too late to perform a cost segregation study. If you missed taking advantage of these benefits in the year the property was initially purchased, constructed or placed in service, you can still do a look-back study as long as the building was acquired or renovated after Dec. 31, 1986. With a look-back study, you will claim all of the prior years’ missed depreciation deductions in one year, and you don’t need to amend your tax return. Building owners can claim these benefits on a Form 3115-Change in Accounting Method through an Internal Revenue Code Section 481(a) adjustment. The change in accounting method is an automatic change under IRS regulations and therefore doesn’t require IRS approval before implementation.
Cost segregation studies can be a valuable source of potential tax deductions for your clients. They should consult a tax adviser for specific guidance on accelerating depreciation, as well as guidance on taking advantage of other tax provisions of the CARES Act.