Cost segregation is an effective tax planning strategy for owners of commercial and rental properties. While little-known, it provides property owners the opportunity to defer tax, improve cash flow, free up capital for investment purposes, and reduce tax liability.
Individuals who own, purchase, renovate, or construct commercial property can benefit from cost segregation, which involves identifying and classifying assets for tax purposes. This approach can offer savings of approximately $150,000 in additional depreciation per $1million of commercial property when compared
to a straight-line depreciation method.
The main benefits of cost segregation include:
In a cost segregation study, certain assets can be re-classified with a 15, 7, or 5-year depreciation schedule. This increases the depreciation amount, thereby reducing taxable income. The segregation of commercial property is found under IRC Sec. 1250.
The IRS recommends that an engineering-based cost segregation study should be performed on both existing and new properties to realize maximum depreciation. Engineering based cost segregation studies provide information required to meet the strict regulations of the IRS. The study findings also serve as a supporting document for the IRS.
Chapter 4 of IRS Cost Segregation Audit Technology Guide (ATG) states that the study should be prepared by someone experienced in cost allocation and estimation, as well as detailed knowledge of the construction process. The individual must have knowledge of the applicable tax laws relating to reclassification of the commercial property for depreciation purposes.
This simply means that the cost segregation engineering study should be conducted by a structural engineer. An analysis of the commercial property by anyone other than an experienced and knowledgeable person may not be considered valid.
The structural engineers who carry out the cost segregation study can reclassify a large number of building components such as plumbing, electrical installations, mechanical components and other short-lived classes of assets. The reclassification can result in substantial tax savings for the property owner.
The fundamental principle of a cost segregation strategy is that a dollar is worth more today than tomorrow. Accelerating the depreciation of the property can greatly reduce taxable income. It can result in tax savings and significantly improved cash flow. The improved cash flow that results due to deferring the tax payments is available for investment in growing the business.
A commercial contractor that I consult with was looking for ways to reduce tax liability. After reviewing the personal tax return, I noticed that the contractor was the member and manager of an LLC that invested in mini-storage units. The LLC had five locations. Upon further review, I noticed that the CPA was depreciating all the property and improvements over a 39½ year schedule. I recommended to the contractor that he hire a team of structural engineers to complete a cost segregation study. The feasibility study showed that the contractor will be able to capture an additional $800,000 in depreciation in the first year alone. Over the next ten years, the contractor can also increase cash flow by over $1.2 million, which he plans to reinvest and build additional storage buildings.