Utilizing a cost segregation study saves money for a building owner by accelerating a building’s tax depreciation and reducing the owner’s taxable income.

For the last several years, a quiet revolution in construction has helped many smart building owners create hundreds of thousands of dollars in tax benefits by properly accelerating tax depreciation – smart building owners’ executives who are aware of it, that is.

Construction and design firms are partnering with accounting firms in order to provide cost segregation studies to project owners. Such a study is used to save money by accelerating a building’s tax depreciation and reducing the owner’s taxable income.

The potential benefits of this kind of study are enormous. Instead of writing off all constructed assets over the standard 39-year federal tax life for buildings, properly categorizing real and personal property assets in 15-, seven-, or five-year tax depreciation lives can lead to significant federal and state income tax savings. In addition, state and local property taxes, and real estate taxes, may also be reduced. Each $1 million in assets reclassified from a 39-year to a five-year depreciable life results in more than $200,000 in net present value savings.

Many expenditures in a building’s construction are eligible for reclassification – from certain heating, ventilation and air conditioning modifications to carpeting and the type of drywall partition used. Appropriate decisions made prior to a building’s construction can save money.

Who determines these tax structures and whether something is personal or real property? Rulings and approved legislation have been established by tax court cases, revenue rulings and passed tax legislation. Thus, it is critical that a cost segregation expert familiar with these rulings is involved early in the life of every construction project including both new construction and renovations.

While it’s true a cost segregation study can be conducted at any point in the construction cycle, the earlier the study is started, the more opportunities there are to find federal, state and local tax benefits in all areas.

How Does a Cost Segregation Study Work?
A building owner hires an accounting firm to work with the designer and the construction company. (A good relationship between the designer/construction company and the owner’s tax department is essential.) This firm is hired to help the owner save tax dollars, which could include making suggestions about the type of building materials and methods of construction that are more tax-advantageous.

Let’s use the aforementioned drywall as an example of how cost segregation can save money for a building owner. Office partitions – regular drywall partitions – are usually classified as a 39-year tax life. However, if the partition is removable and re-usable within the building’s space at a nominal expense and without causing structural damage, that same drywall can be depreciated over five or seven years because it is classified as personal property.

Other examples include carpeting and floor tile. Previously, glued-down carpeting was classified as real property at 39 years. However, due to recent tax court cases, it can now be treated as personal property with a seven-year tax life.

However, grouted hard tile remains classified at 39 years. The accounting firm would suggest that since carpeting is better for tax purposes, it should be the preferred floor finish specified on a project.

Resistance from Architects, Construction Firms
Understandably, the accounting firm performing the study occasionally encounters some resistance from architects who are proud of what they do and resent having a group of “tax guys” make recommendations for different kinds of building materials. It’s a delicate process.

The consultant doesn’t suggest mass changes, and prefers to sit down with the designer before the initial plans are drawn. Special attention is also paid to how each suggestion would impact the project budget and schedule.

Generally the designer and the construction company are willing to incorporate these types of suggestions into the project if they will create savings for the owner. Many times they will even form an alliance with an accounting firm and include this “value-added” idea as a differentiator in their proposal when bidding on the project.

Additional Benefits
Besides tax savings, there are additional benefits of beginning a cost segregation study during the project’s design stage.

Correctly and specifically labeling construction blueprints achieves the result of easily supporting the proper classification of costs in case of an IRS audit. For example, accurately describing which circuit breakers in an electrical panel control which building equipment easily supports an accelerated tax depreciation schedule for portions of the electrical system. Showing that Circuit Breaker A serves microwave ovens and vending machines in a kitchen indicates that power related to those items is personal property and the related electrical cost can be depreciated more quickly. Consequently, showing that Circuit Breaker B controls general building power and lighting results in that portion of the electrical cost being classified with a 39-year tax life.

Starting this process before construction begins and maintaining accurate records creates very defensible studies the IRS will have trouble disproving during a tax investigation.

The accounting firm will also suggest that contractors break out construction cost codes before groundbreaking commences. Most contractors are willing to provide additional cost breakdowns if they know early enough in the process those costs need to be tracked. However, if it is too difficult for the contractor to track certain costs, the cost segregation consultant will estimate the cost of those items from the blueprints.

It should be stressed that while it is best to begin such studies as early in the development process as possible, cost segregation studies can be used to realize tax savings for past building construction, purchases, expansions, renovations and leasehold improvements whose cost recovery deductions have been understated. By using a simple change in accounting method, building owners who understated their depreciation in prior years can retroactively claim the deductions they failed to claim in prior years.

About the Authors
Andy Zaleski and Dan McGrath are senior tax managers in Grant Thornton LLP’s Capital Cost Benefits Group. They are located in Detroit and Chicago respectively. Andy holds Bachelor of Accounting and Master in Taxation degrees and Dan holds Bachelor of Science in Construction Management and Master in Business Administration degrees.

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