If you would like to accelerate current depreciation deductions on newly constructed or acquired facilities and minimize your current tax liability, you may want to consider having a cost segregation study performed on your commercial real estate holdings.
Cost segregation is the process of identifying personal property assets that are grouped with real property assets, and allocating the costs of those assets into appropriate classes of personal property. This enables you to considerably shorten the depreciation recovery period for tax reporting purposes from 39 years to 5, 7, and 15 years. Real property that is eligible for cost segregation includes buildings used in a business that have been purchased, constructed, expanded, or remodeled by the taxpayer.
A cost segregation study can be accomplished through different forms, including a detailed engineering approach using actual cost records, cost estimate approaches, or a sample (or modeling) approach using similar facilities. Ideally, you will want to use qualified engineers and appraisers to perform a cost analysis, particularly for more costly properties, since an allocation made by a seasoned specialist is more likely to withstand an IRS challenge.
Typically, the engineer or specialist will analyze architectural drawings, mechanical and electrical plans, and other blueprints to segregate the structural and general building electrical and mechanical components from those linked to personal property. In addition, certain “soft costs” such as architect and engineering fees may be allocated to all components of the building.
Put simply, cost segregation studies allow businesses to lower current taxes through accelerating depreciation by allocating costs to assets with shorter depreciable lives. There are a number of other benefits, as well:
- Improved cash flow due to decreased current tax payments frees up funds for investment or current operating needs.
- A properly documented cost segregation study performed by a qualified specialist creates an audit trail for IRS purposes.
- A one-time catch up provision allows a current period deduction for the difference between depreciation deducted to date compared to the depreciation that could have been deducted using the cost segregation analysis.
- Cost segregation may provide other tax advantages if the separated components are replaced.
Downsides to cost segregation studies include the cost of performing the study and the triggering of depreciation recapture, which may be subject to ordinary tax rates when the asset is sold. However, the benefits could substantially outweigh these costs.
If you own commercial real estate for your business, you should consider the advantages of having a cost segregation study. Consult with your business advisor and accounting firm to see if cost segregation is a feasible strategy for you.
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