Under United States tax laws and accounting rules, cost segregation is the process of identifying personal property assets that are grouped with real property assets, and further separating out personal assets for tax reporting purposes. A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations. Personal property assets include a building’s non-structural elements, exterior land improvements and a portion of indirect construction costs.
The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for non-residential real property and 27.5 years for residential real property). Personal property assets found in a cost segregation study generally include items that are affixed to the building, but do not relate to the overall operation and maintenance of the building.
Real property eligible for cost segregation includes buildings that have been purchased, constructed, expanded or remodeled since 1987. A cost segregation study is most efficient for new buildings recently constructed, but it can also uncover retroactive tax deductions for older buildings which can generate significant current benefits due to “catch-up" depreciation.
This can be accomplished by switching to the proper class life and taking advantage of revenue procedures that allow taxpayers to deduct in one year the cumulative difference between the depreciation taken on an asset previously placed in service and the amount of depreciation that would have been taken using the proper method. As a result of these procedures, it is possible to significantly increase cashflow from the tax savings generated by the deductions made available with this approach.
Accounting professionals must be able to suggest and help implement cost segregation for their clients, so they can achieve maximum tax savings. In the past when taxpayers purchased real estate, they traditionally allocated 20% of the purchase price to land and 80% to buildings. While the IRS rarely questioned this simplistic approach, purchasers did themselves a financial disservice: They forfeited opportunities to achieve a better tax result.
Effective January 1, 2014, Treas. Reg. § 1.263(a) established new requirements for capitalizing building components and as such, requires the tax payer to separate components into the following nine categories: Heating Ventilation and Air Conditioning; Plumbing Systems; Electrical Systems; All Escalators; All Elevators; Fire Protection and Alarm Systems; Security Systems; Gas Distribution System; and All Other Identifiable Building Systems.
The use of the 80/20 rule is no longer a viable option for tax practitioners due to the current requirements to identify building components under Treas. Reg. § 1.263(a). Further, cost segregation practitioners now separate these building components in their reports to ensure that the analysis will meet or exceed the IRS requirements for building component separations.
|Property Types||*Typical % Qualified|
Medical Office/Dental Office
Research & Development Lab
*Note: Typical Percentage Qualified above includes systems and FF&E commonly found in specific building types.
Overview: The new tax law introduces substantial changes to many areas of the U.S. tax system, including the taxation of individuals, businesses in all industries, multinational enterprises, and other areas. Overall, it provides a net tax reduction of approximately $1.456 trillion over a 10-year “budget window” (according to estimates provided by the Joint Committee on Taxation (JCT) that do not take into account macroeconomic/dynamic effects).
Corporate Rate: The centerpiece of the new law is the permanent reduction in the corporate income tax rate from 35% to 21%. The rate reduction generally took effect on January 1, 2018. The Code provides special rules that affect how the rate change applies to fiscal year corporate filers
Bonus Depreciation (Expensing): The new law temporarily makes expensing the principal capital cost recovery regime, increasing first-year “bonus” depreciation deduction from 50% to 100% and allowing taxpayers to write off immediately the cost of acquisitions of plant and equipment. This expensing regime goes further than pre-enactment law bonus depreciation by applying to both new and used property. The 100% bonus depreciation rule applies to qualified property through 2022 and then ratably phases down over the succeeding five years.
The availability of the deduction could have a number of impacts on business acquisitions. Since buyers can claim an immediate deduction for the cost of qualified property, they may prefer asset acquisitions over stock acquisitions. Further, the availability of the deduction for tangible property (but not for real property or most intangibles) will likely result in negotiations between the parties regarding the appropriate purchase price allocation. The expansion of bonus depreciation to used property also is expected to have a beneficial impact for buyers in the M&A space.
Qualified Improvement Property: Prior to the Act, three types of building improvements—Qualified Leasehold, Restaurant and Retail Improvement property—had a 15-year recovery period and were depreciated using the straight-line method. For years after Dec. 31, 2017, the Act replaces these categories with a revamped Qualified Improvement Property (QIP) classification. The legislative intent was to depreciate these over 15 years using the straight-line method therefore making them eligible for bonus depreciation. However, the necessary language was not included in the final tax reform and, absent a Technical Correction; QIP is depreciated over 39 years and is ineligible for bonus depreciation.
By way of reference, Qualified Improvement Property is any improvement to an interior portion of a building that is nonresidential real property, if the improvement is placed in service after the date the building was first placed in service except for any improvement for which the expenditure is attributable to (1) enlargement of the building, (2) any elevator or escalator, or (3) the internal structural framework of the building. Immediately following the release of the Act, many construction-related firms started circulating marketing material stating that Qualified Improvement Property is eligible for 100% bonus depreciation, but absent a Technical Correction, it is 39-year property and ineligible for bonus.
Repeal of the Corporate AMT: The new law repeals the corporate Alternative Minimum Tax, simplifying U.S. corporate taxation. For corporations that previously paid AMT and hold an inventory of minimum tax credit carryovers, the law allows for the enhanced use of minimum tax credits to offset regular tax and provides that excess minimum tax credits can be refunded from 2018 through 2021.
Net Operating Losses: The new law generally precludes the carryback of NOLs. This eliminates the countercyclical benefit of being able to carry back losses to obtain refunds of taxes paid in prior, flush years, which had been of significant benefit to corporations experiencing financial difficulties or working through a downturn in the business cycle. At the same time, the law provides for the unlimited carryover of NOLs arising in 2018 and later years (prior losses remain subject to the prior 20-year carryover period). This change may have an effect on financial accounting for income taxes and valuation allowances for loss carryovers, to the extent it reduces the likelihood that losses otherwise would have expired unused. Finally, importing a concept from the former corporate AMT, the law imposes a new limitation on the use of NOLs arising in 2018 and later years, providing that these losses cannot offset more than 80% of taxable income.
The new law permits certain non-corporate owners (i.e., owners who are individuals, trusts, or estates) of certain partnerships, S corporations, and sole proprietorships to claim a 20% deduction against domestic qualifying business income. There are numerous limitations on the income eligible for the deduction, with the apparent goal of treating compensation for services as ordinary income that is not eligible for the special deduction. Importantly, the deduction against qualifying income is scheduled to expire for tax years beginning after December 31, 2025. On the revenue raising side, the law also includes significant, but temporary, business loss limitation rules for taxpayers other than C corporations.
“A cost-segregation specialist can perform a nonintrusive yet detailed engineering study of a building's walls, flooring, and ceilings; and its plumbing, electrical, lighting, telecommunications, heating and cooling systems" (Money Doesn't Grow on Trees, But It Could be Hidden in the Walls by William J. Barnes, CPA).
Usually, a construction engineer 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. The study also allocates “soft costs,” such as architect and engineering fees, to all components of the building.
“In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. However, the possession of specific construction knowledge is not the only criterion. Experience in cost estimating and allocation, as well as knowledge of the applicable law, are other important criteria. A quality study identifies the preparer and always references his/her credentials, experience and expertise in the cost segregation area" (www.irs.gov – Cost Segregation Audit Technique Guide – Chapter 4 – Principal Elements of a Quality Cost Segregation Study and Report).
In addition to providing lower taxes, cost segregation can benefit businesses in a number of ways:
Estate Planning. Using cost segregation as an estate planning strategy can create permanent tax benefits. Upon a death where someone owns real estate, this is done by applying a cost segregation to the decedents pre-stepped up tax basis to create a Section 481(a) adjustment.
You need to provide us with as much of the original documentation pertaining to planning, construction, and current tax depreciation as you can. This could include a complete set of construction plans, current tax depreciation records such as tax returns, building cost budget information, final AIA application and a document of certification for payment or other cost information, change orders, direct or indirect costs paid by the owner that are not included in other documents, and other information depending upon the project. If the subject of the study is an acquired property you can provide us with an existing real estate appraisal, Alta survey, site plan, depreciation schedule, or any other information pertinent to the property.
Even if you lack some of the necessary documentation, we can still perform a study for you. Our construction, engineering, and other specialists can do an extensive site visit. They will measure and estimate using currently accepted costing techniques and pricing guides to determine the costs that qualify for shorter recovery life periods. (To determine the costs that qualify, we use the IRS-recommended costing publications Marshall & Swift and RS Means.)
Every project is different depending on size, cost, type, and configuration. Given a few important factors our Tax Savings Calculator can project your tax savings. Enter project information such as total cost, type of facility, placed in service year, etc. and our Tax Savings Calculator will email you a projected tax savings report for your reference. Once we review this information we will provide you with a cost estimate of our fees based on size, cost, and complexity. Tax Savings range from 10 times to 400 times the cost of a study. As an example, a $7,000 study will return a present value of tax savings of $70,000 to $2,800,000.