A Cost Segregation study is a strategic tax tool allowing commercial building owners to accelerate depreciation by reclassifying a portion of the cost from 39-year or 27.5-year depreciable lives to shorter 5-, 7- and 15-year lives. The technique has been receiving increased attention from tax professionals since 1997 when the Hospital Corporation of America case established a philosophy and direction for Cost Segregation studies. Recent favorable tax changes have enhanced the value of the practice.

A Cost Segregation Study uses qualified construction engineers and estimators to allocate portions of buildings’ costs between real estate, land improvements and personal property based on case law and IRS guidance. The result is to accelerate depreciation in the early years of a project’s life, deferring taxes and increasing cash flow during the that period, and repaying taxes in tomorrow’s less valuable dollars. Savings are measured in the net present value of the cash flows over the project’s life.

Case law has established that it is the “ultimate use” of the item that dictates its classification for tax purposes. An example may be a facility’s electrical distribution system. The cost of the system necessary for the operation of the building would be 39-year property, while the costs related to the operation of a press or a computer could be 7- and 5-year property. The portion of the system that provides lighting to the parking lot may qualify for a 15-year life.

An Example
Using the example of a $2 million building we see that in the absence of a Cost Segregation Study, there is no basis for a taxpayer to depreciate a commercial building over less than the 39-year MACRS period.

$350,000 of the cost has been moved to 15-year property and $250,000 to 7-year property. As a result, $366,000 of depreciation has been accelerated and additional cash
flow of $125,000 has been generated by the tax savings from accelerating the depreciation. The net present value
of these cash flows at 6 percent over the life of the building is $95,000.

Identifying items to be segregated is just the beginning. Actually determining the costs legitimately associated with each item is the hardest part. It’s one thing to know that portions of the wiring and electrical load can be depreciated over shorter lives, it’s another to measure and establish the cost of each component in the system. In addition to segregating the direct costs, a portion of any indirect costs also can be segregated. These might include architect fees, legal and engineering fees, contractor’s overhead and profit, permits, bonds and capitalized interest.

IRS Guidelines
A 1999 IRS Legal Memorandum (199921045) says, “As a practical matter, it should be noted that the use of cost segregation studies must be specifically applied by the taxpayer…An accurate Cost Segregation Study may not be based on non-contemporaneous records, reconstructed data, or taxpayer’s estimates or assumptions that have no supporting records.”

In 2004 the IRS published an Audit Technique Guide establishing criteria for a quality study. Using qualified professionals to perform the study will satisfy their requirements and maximize savings, while providing the independent documentation the IRS will look for if the classifications come under scrutiny.

Properties constructed, purchased or with substantial leasehold improvements, or those that have had a step-up in basis since 1987 can benefit. Examples include manufacturing, distribution, retail, auto dealerships, health care, office buildings, golf courses, hotels and motels, apartments, restaurants, funeral homes, banks, airports and more. Those buildings constructed or purchased since 1994 have the best potential for savings. However, all buildings purchased or constructed since 1987 should be evaluated on a cost/benefit basis.

Typical costs that can be reclassified include a portion of site preparation, site utilities, paving, walks and curbing, exterior lighting, fencing, landscaping decorative flooring, wall covering, decorative millwork, dock equipment,
cabinets and portions of electrical and plumbing systems, among others.

If the building was constructed or purchased in prior years, a “catch-up” of depreciation that could have been taken since the building was placed in service is available by filing a Form 3115 for a change in accounting method in the current year. This is an automatic consent by the IRS (Rev. Proc. 99-49). The adjustment created by the increased depreciation is taken against taxable income in the year of change. If it can’t all be used in the current year, it can be carried back or forward depending on the taxpayer’s situation, and it could generate tax refunds.

Cost/Benefit Considerations
Of course, the benefits generated by the study must exceed the cost of the study. There are several points to investigate. First, the taxpayer must be able to use the additional depreciation deductions currently or in the foreseeable future. Second, the benefit can be somewhat reduced if the taxpayer is in an AMT position. Third, if the taxpayer contemplates the sale of the building, depreciation recapture, and 1031 exchange issues need to be explored.

Whether a building owner has constructed, purchased or improved a building, a Cost Segregation Study provides the opportunity to move items of cost from longer to shorter depreciable lives, thereby accelerating depreciation deductions and improving cash flow through tax
deferrals. The benefits can be significant. Each commercial building should be evaluated to see if a study will benefit
the taxpayer.

About the Author
Dennis M. Duffy is the president of Duffy & Company Cost Segregation Services, Inc. He is a CPA with a background in the construction industry. His firm has conducted engineering-based cost segregation studies since 2002.

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