by Jeff Thill and Ron Price

Your company’s real estate holdings compose a significant capital investment. By using a standard asset depreciation technique called cost segregation, your business can reap tax benefits and increase its cash flow.

Cost segregation views real estate acquisitions not only as land and buildings, but also tangible personal property and land improvements. It allows the purchaser to segregate assets to achieve faster depreciation deductions so cash flow is increased.

Normally, the costs incurred in constructing or acquiring a building comprise the building itself and other structural components. Absent evidence to the contrary, all costs of a building construction or acquisition are required to be depreciated over a recovery period of 39 years.

However, certain items included in the total construction or acquisition costs that are not structural components, but are instead integral parts of other personal property, may be depreciated over shorter periods (typically five to seven years). In addition, certain land improvements may be recovered over a 15-year period.

Start with a cost segregation study

To gain shorter depreciable lives where applicable, companies must separate personal property and facility improvement costs from building costs. This process is referred to as a cost segregation study. The study can provide significant tax deferral and cash flow benefits through the acceleration of depreciation expense.

A cost segregation study can be applied to new buildings presently under construction, existing buildings undergoing renovation, or purchases of existing buildings. Studies can also be performed for buildings constructed or purchased in an earlier year but that have not yet benefited from cost segregation. In fact, IRS rules allow you to prospectively deduct depreciation you were legally entitled to but did not claim (e.g., because of erroneous classification of property as a 39-year depreciable building).

Often, property owners themselves are able to identify certain nonstructural items that qualify for accelerated depreciation. However, the real value in a cost segregation study comes from identifying mechanical, electrical, and plumbing assets and determining what portions of these assets can be classified as personal rather than real property. In fact, a study should involve several steps, including a review of blueprints and specifications, an on-site tour to identify items of personal property or land improvements, a cost analysis to assign appropriate value to property, and the assignment of appropriate depreciable life to each asset.

Benefits to your business

A cost segregation study is not a tax reduction strategy; it’s a tax deferral strategy. The benefit lies in freeing up cash flow, particularly in the early years of a project or purchase.

Because of the time value of money, the biggest advantage of cost segregation is the net present value of the tax savings generated by accelerated depreciation deductions. A typical cost segregation study can generate cash flow savings of 10 to 20 times the initial investment in the study. Additional tax benefits include decreased realty transfer taxes and reduced real property taxes.

In addition to tax relief, a cost segregation study will offer clear and convincing evidence of the costs and classifications of assets in the event of an IRS inquiry. Having a properly documented cost segregation study that employs the engineering and cost-estimating procedures recognized in IRS rulings and judicial decisions can help resolve IRS inquiries at the earliest stages, avoiding unfavorable audit adjustments.

Cost segregation is by no means an aggressive or risky tax strategy, and court rulings have supported the practice for decades. In 1997, the United States Tax Court ruled that segregating costs for tax purposes was allowable. As a result, cost segregation has become an accepted – although somewhat underutilized – tax-planning tool.

Given the dramatic tax savings, isn’t it time to put cost segregation to use in your business?

About the authors

Jeff Thill is a Wipfli partner serving manufacturing and wholesale entities ranging in size from large, widely owned companies to smaller, family-owned businesses.

Ron Price is a senior manager providing tax research, compliance, and consulting services to manufacturers, helping them attain their financial goals. To learn more about cost segregation, please contact Jeff at our St. Paul office at 651.766.2862, or e-mail him at jthill@wipfli.com.