Authored by Wendy Landrum and Scott Shavel
A cost segregation study is an in-depth analysis of the costs associated with the construction, acquisition or renovation of owned or leased buildings for proper tax classification. A study identifies assets and their associated costs that may be eligible for shorter tax recovery periods resulting in accelerated depreciation deductions. Building property generally has a 39-year tax recovery period for nonresidential property or 27.5 years for residential property. Identification of nonbuilding components included in the building cost basis may be eligible for tax recovery periods of five years, seven years or 15 years.
Items analyzed during a cost segregation study include real property (the building and its structural components), tangible personal property (e.g., carpeting, casework and vinyl floor tile) and items that have both a building and nonbuilding component. The determination of the tax recovery periods of such items is made by analysis of the permanency and method of attachment of the item. Generally, if the item is permanent in nature, it is building property. However, if the item is easily removable, it typically is considered nonbuilding property, having a shorter tax recovery period. Other considerations in the analysis of whether the item may be nonbuilding property is if it is accessorial to the taxpayer’s business or decorative assets.
The most common items requiring an in-depth analysis are lighting, power and HVAC. Without a cost segregation study, a majority of these costs would remain in building property with a long tax recovery period. But using cost segregation drawing review and take-off estimation, light fixtures can be identified as either building lighting or supplemental and task lighting or decorative lighting with a shorter tax recovery period. Power can be identified as related either to the operation and maintenance of the building or as process-related power (such as cubicles, data room, manufacturing equipment, redundant power, etc.) over a shorter tax recovery period. HVAC can also be identified as either building property for the operation of the building or nonbuilding property for supplemental HVAC serving computer rooms, kitchens, manufacturing areas, etc.
Most industries and property types can benefit from a cost segregation study, including:
- Headquarter buildings
- Commercial office buildings
- Retail, restaurants and grocery stores
- Manufacturing and industrial facilities
- Financial institutions and bank branches
- Apartments and assisted living facilities
The level of benefit is generally based on the use of the property. For example, a storage warehouse will have less benefit from a cost segregation study because there is inherently less nonbuilding property included, whereas heavy manufacturing, medical and R&D facilities have more extensive HVAC and power dedicated to nonbuilding components, thus a higher benefit results from a cost segregation study.
The identification of nonbuilding components eligible for shorter tax recovery periods results in accelerated depreciation deductions. The reclassification of assets from longer to shorter tax recovery periods may also make these assets eligible for bonus depreciation when they otherwise were not resulting in even more substantial present value tax savings.
For property placed in service after Dec. 31, 2015, bonus depreciation is available for qualified property that meets the following requirements:
- New MACRS property with a recovery period of 20 years or less, computer software, water utility property or qualified improvement property;
- Original use must begin with the taxpayer; and
- Placed in service before Jan. 1, 2020.
“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, excluding: 1) enlargements; 2) elevators/escalators; and 3) internal structural framework. The improvements do not need to be made pursuant to a lease. Qualified improvement property is depreciated over a 39-year tax recovery period and is eligible for bonus depreciation.
Qualified leasehold improvement property is any improvement to an interior portion of a building, excluding enlargements, elevators/escalators, common area work and internal structural framework, that is nonresidential real property and placed in service more than three years after the date the building was first placed in service. The landlord and tenant cannot be a related party. The improvement may be made by the lessee or by the lessor but must be made pursuant to a lease. Qualified leasehold improvement property has a 15-year tax recovery period and is eligible for bonus depreciation.
The bonus depreciation percentage is 50 percent for property placed in service during 2015, 2016 and 2017, but then phases down to 40 percent in 2018 and 30 percent in 2019.
If the building is acquired, and hence not the original use of the property, it is not eligible as qualified improvement property or qualified leasehold improvement property. Therefore, the reclassification of assets from 39-year building property, or 15-year leasehold improvements, to 5-year or 7-year property will now qualify for 50 percent bonus depreciation in addition to accelerated depreciation from a shorter tax recovery period. Renovated building costs incurred in 2016 are generally qualified improvement property or qualified leasehold improvement property with 50 percent bonus depreciation so these assets will benefit only from the reclassification to a shorter tax recovery period.
The combination of accelerated depreciation deductions from both reclassification to a shorter recovery period and bonus depreciation result in an increase to short-term cash flow by deferring income tax payments. Typically, cost segregation creates a tax savings of 2 to 5 percent of the total basis of the property depending on the type and complexity of the property. The accelerated depreciation deduction resulting from a cost segregation study is a timing difference as you will get the same amount of depreciation deduction over the life of the asset, however, you will get the larger deductions sooner when depreciated over a shorter recovery period.
While the primary benefit of a cost segregation study is present value tax savings, permanent tax reductions may also exist considering potential tax rate reductions under tax reform proposals presented by the president and various Republican congressional leaders. Taxpayers that have not yet filed their 2016 federal income tax return may have an opportunity to generate one-time permanent tax savings by accelerating deductions in 2016 at the current higher tax rates.
Taxpayers that constructed, renovated or acquired a building placed in service in 2016 may want to consider a cost segregation study to maximize tax deductions. Alternatively, if the building was placed in service prior to 2016, and no cost segregation study was done at the time, a retroactive cost segregation study can be done in 2016 and the section 481(a) catch-up adjustment can all be claimed on the 2016 tax return by filing a change in accounting method.
Lastly, there may be a significant impact on the viability of cost segregation studies under the proposed tax regimes. While President Trump’s recently announced tax plan made no mention of this, his previous proposal would allow manufacturing companies to elect to expense all capital investments, negating the need for any cost segregation studies as all costs would be immediately expensed. Under the House tax blueprint, there would be an immediate deduction for investments in tangible property, other than land, eliminating the need for cost segregation studies for all industries. Both proposals, whether affecting just manufacturers or all industries, would be extremely favorable to taxpayers.
What the future holds for cost segregation studies is unknown, but given the likelihood of lower tax rates in 2017 or beyond, significant permanent tax savings may be realized for 2016 by performing cost segregation studies on current or historic properties.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.