Cost Segregation Depreciation - John R. Dundon II, Enrolled Agent
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Cost Segregation Depreciation

Cost Segregation Depreciation

For income tax depreciation purposes there are two major types of assets: Sec. 1250 real property and Sec. 1245 personal property. When owners acquire commercial property or tenants invest in leasehold improvements, many only allocate the purchase price between land (non-depreciable) and building (depreciated as a 39-year asset over 40 years).

However, by taking advantage of IRS sanctioned rules in the tax law, property may be further segregated within these two sections by identifying 5-year and 7-year personal property, 15-year land improvements, and 27.5-year residential and 39-year nonresidential real property.

For example the IRS allowable 5 and 7 year personal property items include electrical service and distribution to dedicated computer equipment and appliances; plumbing that services dedicated kitchen equipment; and many types of nonstructural furniture, finishes, fixtures and equipment. 15 year land improvements include site utilities, some pools, landscaping, paving, curbs and gutters.

As a direct result of segregating these IRS allowable categories, depreciation expense increases in the first several years of the property’s life. The increase in depreciation expense applied against generated revenues decreases taxable earnings in those years, resulting in substantial present-value tax savings for building owners who purchased their buildings after 1986.

Cost segregation is applicable and cost effective for buildings of varying cost basis, starting in value at $250,000 as well as tenant leasehold improvements starting in value at $80,000.

BENEFITS OF COST SEGREGATION DEPRECIATION

Calculating Cost Segregation Depreciation involves not only knowledge of tax law but of construction methodology and an understanding of which construction components apply to which 5, 7, 15 year, etc category. To generate the maximum amount of tax savings requires a detailed Cost Segregation Engineering Study. Specialized companies employ construction engineers and tax professionals to document and prepare these Cost Segregation Engineering Studies.

Naturally these firms charge a fee for their services. But the benefits of a proper fixed-fee cost segregation study will pay for the fee several times over, giving a healthy upward push to the owner’s cash flow and a significant ROI on the investment in the Study. Additionally, many of these firms will provide free estimates to review before committing to any course of action.

As a note, IRS guidelines prohibit a fee based pricing structure derived from the amount of tax benefit gained from the study.

“LOST” DEPRECIATION FROM EARLIER FILINGS CAN BE RECOUPED

Section 481(a) of the Internal Revenue Code enables property owners to “catch up” past years’ understated depreciation with a one-year lump-sum adjustment.

Therefore, if a property was acquired in 2003 and a Cost Segregation Engineering Study finds that $400,000 more could have been depreciated from 2003 to 2007, the owner can apply that additional amount to 2008 depreciation, in effect making up for the four years of increased depreciation that was lost.

PROPERTY IMPROVEMENT BY BUILDING OWNERS AND TENANTS CAN BENEFIT AS WELL

Cost Segregation Engineering Studies often are performed on capital projects in existing commercial property with even more beneficial results. Because large-scale renovations include repairs to and replacements of structural and nonstructural items, they normally are depreciated as a 39-year asset. However, it is not uncommon for a Cost Segregation Engineering Study to enable accelerated depreciation of more than half of the total renovation cost. Using a $6- million renovation as an example, this translates into more than $1 million in tax savings during the first four years and more than $500,000 present value tax savings.

There are certain circumstances where initiating Cost Segregation Depreciation is of no benefit. Building owners who plan to sell their property in 2-5 years; properties nearing the end of their depreciable life; owners who cannot use any more tax deductions; and non-profits would not benefit from Cost Segregation Depreciation.

COST SEGREGATION CAN BE APPLIED WITHOUT RE-FILING PREVIOUS YEARS TAXES. Re-filing is not necessary. In order to bring this new depreciation forward you will submit a 31.15 Change in Accounting Form. Court rulings allows for an “automatic approval protocol”. In other words all you have to do is complete the form and send it in with the client’s financials. Additionally the IRS ruled there would be no filing fee for the Change in Accounting Form.



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