1. The concept is simple.
Any given property contains a multitude of different assets, and each of them can be expected to have a different useful life. For example, you can confidently expect marble flooring to last a lot longer than say, carpet tile. The IRS provides guidelines that indicate how long different assets might last, using a system called MACRS (Modified Asset Cost Recovery System.) The default MACRS class-life for an asset is 39 years. If no cost segregation study is performed, all assets will depreciate over 39 years for commercial property or 27.5 years for residential. Now that makes sense for marble flooring, but not for carpet tile. Why should carpet tile just sit on the books, being depreciated over 39 long years?
In a cost segregation study, engineers identify and quantify all building assets, and then assign each asset a cost. These costs are then segregated into different categories according to their asset class lives. Base building or “shell” assets remain 39-year assets, but many items can be moved into shorter-lived class lives:
- 5-Year Assets: carpet tile, counters, sinks, specialty lighting, dedicated outlets, fire extinguishers and more
- 7-Year Assets: office furniture
- 15-Year Assets: land improvements like drainage pipes, parking lots, landscaping, outdoor lighting, and more
By segregating these assets into shorter-lived categories, they can be depreciated more quickly, resulting in tax savings.
2. The execution can be challenging.
Since the concept of cost segregation is fairly easy to grasp, many people think that performing a cost segregation study must be fairly easy as well. Actually, performing a quality cost segregation study is no simple feat. Engineers must draw on their knowledge of construction technologies and costs as they meticulously work their way through a project site, laboring to account for every possible asset, and thereby save the client every possible dollar. After the site visit the real work begins with engineers studying plans, doing quantity takeoffs, and crunching numbers. Study results must then be analyzed from tax and technical perspectives, to ensure complete accuracy and compliance with IRS-regulations.
3. Cost segregation can be performed on almost any type of commercial real estate.
Properties like office buildings, hotels, and retail spaces often come to mind when people think of cost segregation, but it can be performed on almost any type of commercial real estate. In fact, some of the hottest property types for cost seg include:
- Industrial/manufacturing facilities
- Auto dealerships
- Self-storage facilities
- Medical facilities
Cost segregation can even be performed on non-profit tenants in otherwise for-profit spaces, a trend we’re seeing quite a bit of lately.
4. Cost segregation doesn’t create new deductions.
Moving assets into shorter-lived categories doesn’t magically generate new deductions. It just accelerates the deductions so the taxpayer gets them sooner, taking advantage of the time-value of money.
5. Accelerated depreciation is just the beginning — cost segregation is also the key to an additional incentive known as bonus depreciation.
Bonus depreciation permits the immediate write-off of the full purchase price of eligible assets in addition to other depreciation. New and used assets with class lives of 20-years or less are eligible for this “bonus” which significantly boosts tax savings. Cost segregation is the primary vehicle used to determine and document which assets have eligible class lives and are therefore eligible for this powerful incentive.
The bonus depreciation rate is 100% for eligible assets placed-in-service between 1/1/2018 and 12/31/2022. The rate will decrease to 80% in 2023, and will continue to decline by 20% annually through 2026.
While it’s certainly a bonus – no pun intended – if you can take advantage of that 100% rate while it’s here, cost segregation studies will still bring great benefit, even at lower bonus rates.
6. Bonus-eligible QIP has made cost segregation even more lucrative.
Qualified Improvement Property (QIP) is defined as any improvement to an interior portion of a building which is nonresidential real property if the improvement is placed-in-service after the date the building was first placed-in-service by any taxpayer. (If you want more clarity on this definition, read our blog that breaks it down piece by piece.) The CARES Act of 2020 assigned QIP a 15-year recovery period. By assigning QIP a class-life of less than 20 years, the CARES Act made QIP bonus-eligible, in a huge boon for taxpayers.
A cost segregation study is the key to this incentive as well, as it provides the comprehensive data required to categorize and assign cost values to QIP assets.
7. Cost segregation is not a “now or never” strategy.
Ideally, it’s best to perform a cost segregation study immediately after a property is placed-in-service, to maximize savings from day 1. However, if that was not possible, the IRS allows for recapture of the benefits from previous years using a “look-back” cost segregation study. By reclassifying assets to their correct lives, entities can “catch-up” on all the depreciation they would have gotten had the study been performed on day 1!
8. Cost segregation is the key to energy-efficient tax incentives.
Being environmentally conscious is crucial these days, and in addition to building new properties responsibly, many builders are retrofitting yesterday’s properties to meet today’s standards. A cost segregation study provides the data required to take advantage of the EPAct 179D tax deduction for commercial/residential rental properties at least four stories high. By incorporating energy-efficient improvements in lighting, HVAC, or building envelope, taxpayers might be eligible for a depreciation deduction of up to $1.80/improved square foot.
9. Cost segregation is even useful before a renovation.
It might seem counterintuitive to perform a detailed study of assets that you plan to dispose of. Why quantify assets that are on their way out?
However, if these assets are quantified through a cost segregation study, you can use that data to take advantage of a strategy called Partial Asset Disposition (PAD). PAD permits a taxpayer to write off the remaining depreciable basis of an asset that was disposed of in the year it was removed. This can be an incredible tax-savings strategy, but requires a complete record of the assets in question.
10. Cost segregation is the key to real estate tax savings, but all providers are not created equal.
You want to be certain that you and your clients are in the best possible hands. To select a quality cost-segregation provider, consider these questions:
- How many studies have been performed by your team?
- Will my study be performed by a degreed engineer? Do you have ASCSP-Certified team members on staff?
- What methodology is used to create the report? What kind of technical/tax review process is involved?
- How frequently will you communicate with me/my client? Can you tailor your level of engagement to our preferences?
- Will you stand behind your work product in the unlikely event of an audit?
- Can you help us craft a comprehensive tax plan that will serve us now and in the future?
- Are you selling a one-time service based on price, or are we building a long-term relationship built on quality and trust?Have a question? Contact Capstan Tax Strategies, Bruce Johnson Founding Partner
- Written By Andy Murdie, Engineer, Capstan Tax Strategies
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