C is for Cost Seg PR

“C” is for COST SEGREGATION

By Tim Crockett

You probably have heard the quote from Aristotle, “The whole is greater than the sum of the parts.” Well, here’s a case where the reverse is true. The IRS allows a building owner to deduct 1/39^th of their building each year for 39 years.  However, if they use Cost Segregation, (a process which divides the building into many separate pieces generates more tax savings than doing it all as one, and takes into consideration that many construction components of the building have a shorter life than 39 years and may be classified as “personal property”).  The owner (ie KEEN through our team of Cost Seg Engineers) can identify those components which qualify and accelerate your depreciation.  Since many investors do not hold their investment property for 39 years, they miss out on the benefits of some of that depreciation. At KEEN we can assist our property owner clients to optimize their investments by offering Cost Segregation Service.

News Flash, Lowering your tax bill is good!

More for those of you who like getting into the weeds a bit…

Before 1981, taxpayers could break real estate into components, which allowed part of the cost to qualify for the investment credit. The identified personal property also qualified for a much shorter life for depreciation. The Economic Recovery Tax Act of 1981, P.L. 97-34, repealed “component depreciation”, but the accompanying 15-year life for buildings only temporarily removed some of the sting, because the modified accelerated cost recovery system provisions of the Tax Reform Act of 1986, P.L. 99-514, increased the cost-recovery period to 27.5 years for residential and 39 years for nonresidential buildings.

Taxpayers, however, found refuge in the definition of personal property left over from the repealed investment credit. In the watershed case of Hospital Corp. of America (109 T.C. 21 (1997)), the Tax Court relied on the Sec. 38 definition of personal property, which allowed the taxpayer to use a cost technique that resulted in the classification of many parts of its hospitals as personal property. The IRS eventually agreed that cost segregation does not constitute component depreciation. Current IRS revenue procedures and audit manuals outline what is required to produce a cost-segregation report that passes IRS scrutiny.

SEGREGATING THE BUILDING

Cost segregation or allocating costs or values of a building’s components into appropriate classes of personal property to shorten their depreciation recovery period, can be applied to buildings used in a business that were recently constructed, purchased, expanded or remodeled by the taxpayer.

In addition, cost segregation can be used for buildings that have been in service for some time, as well as some buildings that have been sold.

For buildings already in service, depreciation deductions for prior years can be recomputed, and a one-time catch-up provision (a Sec. 481(a) adjustment) allows a current-period deduction for the difference between depreciation deducted to date and that which could have been deducted using cost segregation (Rev. Proc. 2002-9), instead of having to amend prior-year returns. The IRS has taken the position that a change in recovery period is a change in accounting method. Hence, to implement the catch-up provision, the taxpayer must complete and timely file Form 3115, Application for Change in Accounting Method. For buildings that have been sold in a prior tax period, the taxpayer must also be eligible to file an amended return for the tax year of the sale.

Although the most significant benefit of cost segregation is the acceleration of depreciation due to maximizing the costs allocated to personal property and land improvements, segregating the building may have other tax advantages if the separated component is eventually replaced. For example, the unrecovered cost of an old roof could be written off when replaced rather than continuing to be spread over the remaining portion of the original 27.5- or 39-year period, as would be the case if there had been no cost segregation. If not written off, the replaced roof continues to be depreciated (along with the new roof) for the remainder of its “life” even though it has been replaced.

Disclaimer, Neither I nor KEEN Realty is a CPA nor do we offer tax advice.