Cost Segregation

The the process of identifying costs and assets, and their classification for tax purposes. Applied to reducing current tax liability and deferring taxes.

What is Cost Segregation?

Cost segregation is a tax planning strategy that involves identifying costs and assets within a property, and classifying them for tax purposes in order to reduce current tax liability and defer taxes. 

By identifying assets that can be depreciated over a shorter period of time, taxpayers can accelerate depreciation and reduce their tax liability. 

This strategy is most beneficial for properties with a high value and long-term holding period, such as commercial buildings, rental properties, and manufacturing facilities. Cost segregation can be applied to both newly constructed and previously constructed properties, and is a commonly accepted tax planning strategy that is supported by the IRS.

What types of properties can cost segregation be applied to?

Cost segregation can be applied to a wide range of properties, including commercial buildings, rental properties, manufacturing facilities, hotels, restaurants, and retail spaces. Essentially, any property that contains building components, structural systems, or site improvements that can be separately identified and valued can potentially benefit from cost segregation. 

For example, a commercial office building might have numerous components that can be separately identified and valued, such as plumbing, electrical, and lighting systems, HVAC equipment, and flooring. By identifying these components and classifying them for tax purposes, the property owner can accelerate depreciation and reduce their tax liability. 

Similarly, a manufacturing facility might have specialized equipment, such as conveyor systems, robotics, and production lines, that can be separately identified and valued for tax purposes.

How does cost segregation reduce tax liability?

Cost segregation allows property owners to accelerate the depreciation of certain assets within a commercial property. By identifying and reclassifying certain assets as personal property or land improvements, rather than real property, taxpayers can take advantage of shorter depreciation schedules and realize larger tax deductions in the earlier years of ownership.

To give you an example, let's say that a property owner purchases a commercial building for $2 million. Without cost segregation, the entire property would be depreciated over 39 years, resulting in an annual depreciation expense of approximately $51,300.

However, if a cost segregation study is performed and it's determined that 20% of the building's value can be allocated to personal property, such as furniture and fixtures, and land improvements, such as landscaping and parking lots, then those assets can be depreciated over 5, 7, or 15 years, depending on their useful life.

Assuming that $400,000 of the building's value is allocated to personal property and land improvements, the annual depreciation expense for those assets would be approximately $88,900, resulting in a tax deduction of $37,600 in the first year of ownership.

By accelerating the depreciation of certain assets, the property owner can reduce their taxable income and save money on their tax bill. This can be particularly beneficial in the early years of ownership when cash flow may be tight and tax savings can be reinvested in the property or used to fund other business activities.

Can cost segregation be applied to previously constructed properties?

Cost segregation can be applied to previously constructed properties. In fact, many property owners are surprised to learn that they can still benefit from cost segregation even if they have owned the property for several years.

A cost segregation study can be performed at any time during the ownership of a property, including after it has been fully constructed and placed in service. This means that if you purchased a property several years ago and did not perform a cost segregation study at that time, you may still be able to take advantage of the tax savings that come with cost segregation.

Let's say that you purchased a commercial property for $5 million five years ago and have been depreciating it over 39 years. However, after speaking with a tax professional, you decide to have a cost segregation study performed on the property.

The study identifies $1 million of the property's value that can be reclassified as personal property and land improvements, and depreciated over 5, 7, or 15 years. This results in an accelerated depreciation expense of approximately $153,000 per year for the reclassified assets, compared to $128,000 per year without cost segregation.

By applying cost segregation to a previously constructed property, you can potentially increase your tax deductions and reduce your tax liability for prior years. This can result in a significant amount of tax savings, especially if you own multiple properties or have owned the property for several years.

Does cost segregation increase the risk of an audit?

The short answer is no, cost segregation does not necessarily increase the risk of an audit. While it's true that the IRS may take a closer look at tax returns that include accelerated depreciation, such as those resulting from cost segregation, there are several factors that can minimize the risk of an audit. Also ensure to 

• Work with a reputable and experienced tax professional who can ensure that the cost segregation study is performed accurately and in compliance with IRS guidelines. This can help minimize the risk of errors or misclassifications that could trigger an audit.
• Keep detailed and accurate records of all costs associated with the property, including the cost segregation study itself. This can help provide documentation and support in the event of an audit.

Remember that cost segregation is a legitimate tax planning strategy that is recognized by the IRS. In fact, the IRS has issued guidance on cost segregation and provides a safe harbor for certain assets that are commonly reclassified through cost segregation studies.

In other words, if cost segregation is performed correctly and in compliance with IRS guidelines, it should not increase the risk of an audit. On the contrary, cost segregation can actually help reduce the risk of errors on tax returns and ensure that property owners are taking advantage of all available tax deductions.

Conclusion

Whether you own a single property or a large portfolio of commercial real estate, cost segregation is a tax planning strategy that is worth exploring. It can help you save money, improve your cash flow, and achieve long-term financial success.

While there may be some concern about the risk of an audit, working with an experienced tax professional and following IRS guidelines can help minimize that risk and ensure compliance with all tax laws and regulations.

‍