Do cost segregation studies make sense post-tax reform?
Cost segregation studies can fit into a few different categories. For the purposes of this article, we will focus on acquired property, new construction and building renovations.
These cost segregation studies combine accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property. This could potentially allow you to accelerate depreciation deductions, thus reducing taxes and boosting cash flow.
Due to new rules and limitations for depreciation and expensing under the Tax Cuts and Jobs Act (TCJA), the potential benefits are now greater.
Cost Segregation 101
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 recently issued final tangible property regulations.
How Tax Reform Impacted Cost Segregation Studies
The Tax Cost and Jobs Act (TCJA) enhanced certain depreciation-related tax breaks which may also enhance the benefits of a cost segregation study. Among other things, the TCJA permanently increased limits on Section 179 expensing. Section 179 allows you to immediately deduct the entire cost of qualifying equipment or other fixed assets up to specified thresholds.
Under Section 179 expensing, taxpayers can take a current deduction for the cost of qualified new or used business property placed in service in the tax year, up to certain limits. For 2018, the TCJA doubled the maximum Section 179 deduction, to $1 million, with a phaseout threshold of $2.5 million. For 2019, the deduction limit increases to $1.02 million and the phaseout threshold rises to $2.55 million. Both amounts will be adjusted for inflation in future years. Contact us with questions.
The TCJA expanded 15-year-property treatment to apply to qualified improvement property. Previously, this tax break was limited to qualified leasehold-improvement, retail-improvement, and restaurant property. It also temporarily increased first-year bonus depreciation to 100% (from 50%).
Look-Back Cost Segregation Studies
If your business invested in depreciable buildings or improvements in previous years, it’s not too late to take advantage of a cost segregation study. A “look-back” cost segregation study allows you to claim missed deductions back to 1987.
To claim these tax benefits, a business should file Form 3115, “Application for Change in Accounting Method,” with the IRS and claim a one-time “catch-up” deduction the current year’s return. There’s no need to amend previous years’ returns.
Property and Sales Tax Considerations
Businesses can also use cost segregation studies to support the property tax or sales tax treatment of certain items. For example, a cost segregation study can be used to document the cost of a tax-exempt property. This would be helpful for manufacturers since many states exempt property used in manufacturing.
If your business decides to make changes based on a cost segregation study, please note that certain property may be treated differently for income tax and property tax purposes, and reporting mistakes can lead to double taxation. Suppose your state has a personal property tax and the business reclassifies certain building components as personal property for income tax purposes. If the business reports these items to the state as taxable personal property, but state law treats them as part of the real estate for real property tax purposes, they may be taxed twice: once as personal property and once as real property.
To avoid double taxation, be sure you have systems in place to track the costs of these items separately for income tax and property tax purposes.
Is a Cost Segregation Study Right for You?
Cost segregation studies may yield substantial benefits, but they’re not right for every business. To find out whether a study would be worthwhile, consult your tax advisor to do an initial evaluation to assess the potential tax savings and discuss the possible interplay that may prove beneficial depending on your situation.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.