As the economy continues to improve and company profits rebound, many businesses will give 45 percent of their hard earned profits back to the federal government in the form of taxes. This leaves very little left over to reinvest back into the company.
For manufacturers in particular, offsetting profits with deductions can be challenging. This is because many invest significant money back into their building facility and infrastructure to support their manufacturing activity. These costs can take up to 39 years to write-off under the tax reporting rules, impacting cash flows and working capital.
Help is available in the form of a strategic tax savings tool known as a Cost Segregation Study. This allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes. This presents a unique opportunity for additional accelerated deductions when combined with the recent favorable tax law changes under the Repair Regulations, which now allow companies to more favorably write-off capitalized repairs and maintenance incurred in the current and prior years.
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. In addition to new construction, taxpayers that have incurred significant costs for improvements and additions to existing buildings over the last 15 years would also benefit.
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:
- Lower current tax payments can improve cash flow and free 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.
Under the new Repair Regulations, the Internal Revenue Service has provided taxpayers with a limited opportunity on their 2014 tax returns to immediately expense or dispose of costs that have been improperly capitalized on their prior year tax returns as an improvement to the building or machinery. Examples of building improvements that may now qualify as an immediate expense are roof membrane replacements, new air conditioning units, window replacements, and “refresh” office remodeling.
Taxpayers also have a limited opportunity to write-off the cost of old building components that are being replaced with new building components that require capitalization (e.g. write off the cost of your old roof for a new roof replacement). Before this limited window closes, taxpayers should review their current depreciation schedule to identify any of these opportunities.
If you constructed, purchased, expanded, or remodeled any kind of real estate for your business in the past 15 years, you should consider the advantage of having a cost segregation study. If you have capitalized any repairs and maintenance to your building in the last 15 years you should also consider the opportunities to write off the remaining basis of these costs in the current year under the new Repair Regulations. Consult with your business advisor and accounting firm to see if a Cost Segregation and Repair Regulation Study is a feasible strategy for you.
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