It is reasonable to be concerned that taking more depreciation now will lead to higher taxes later when the property is sold. Although it is true that a cost segregation decreases the investor’s tax basis, which thereby increases the future capital gains on the property, it can still be beneficial to have a cost segregation study done. Many taxpayers prefer deferring taxes into the future in order to have cash available that they can put into their business today.
IRS rules generally allow businesses to depreciate commercial buildings over 39 years (27½ years for residential properties). In most cases, a business will depreciate a building’s structural components such as walls, windows, HVAC systems, elevators, plumbing and wiring as well as the building.
Personal business property such as equipment, machinery, furniture and fixtures is also eligible for accelerated depreciation, but usually over five or seven years. Land improvements including fences, outdoor lighting and parking lots are depreciable over 15 years.
It is common for businesses to allocate all or most of a building’s acquisition or construction costs to real property and overlook the opportunities to allocate costs to shorter-lived personal property or land improvements. For instance, computers and furniture have obvious distinctions between real and personal property, but often the line between the two is less clear. Items that appear to be part of a building may be personal property, like a removable wall and floor coverings, removable partitions, awnings and canopies, window treatments, signs and decorative lighting.
In some cases where real property serves more of a business function than a structural purpose, it may qualify as personal property. This includes reinforced flooring to support heavy manufacturing equipment, electrical or plumbing installations required to operate specialized equipment or dedicated cooling systems for data processing rooms.
Although the relative costs and benefits of a cost segregation study depend on your facts and circumstances, it can be a valuable investment. Let’s say the business acquired a nonresidential commercial building for $5 million on January 1. If the entire purchase price is allocated to 39-year real property, the business is entitled to claim $123,050 (2.461% of $5 million) in depreciation deductions the first year. A cost segregation study may reveal that you can allocate $1 million in costs to five-year property eligible for accelerated depreciation. Reallocating the purchase price increases your first-year depreciation deductions to $298,440 ($4 million × 2.461%, plus $1 million × 20%).
A cost segregation study can assist you in making partial asset disposition elections and deducting removal costs under the tangible property regulations.