If you are constructing a new building, expanding a current facility, or purchasing an existing commercial or residential property, you might be able to save significantly on taxes by arranging for an engineering-based cost segregation study. Such studies can help improve cash flow on new construction, but they also can provide tax and cash flow benefits for existing structures—even those you acquired several years ago.

Overview of the Concept

Buildings, land improvements, and various types of personal property have different depreciation lives. Cost segregation is the process of analyzing building costs, components, drawings, and documents to determine which property components are eligible for depreciation over shorter lives, providing a significant tax benefit.

For example, the class life of a commercial building is generally 39 years. Residential properties such as apartments and nursing homes generally have a 27.5-year class life. But certain components and building systems—such as specialized electrical, plumbing, mechanical, and finish components—can qualify for shorter class lives, so they can be depreciated over five, seven, 10 or 15 years.

For many commercial buildings, it is not unusual to find that 25 to 50 percent of the total costs are eligible for reclassification into shorter life asset classes. In other words, a cost segregation study for a $1 million property could generate more than $250,000 of accelerated depreciation. As the depreciation deductions increase, current tax liability decreases, which improves cash flow.

Tax Reform Increases Potential Benefits

Cost segregation studies became even more important when the Tax Cuts and Jobs Act (TCJA) of 2017 extended bonus depreciation, the 100 percent expensing of assets with a class life of 20 years or less. This means things like equipment, furniture, landscaping, fencing, and parking lots do not have to be depreciated over five, seven, or 15 years, but instead can be written off 100 percent in the first year.

In addition, the TCJA expanded Section 179 to include certain improvements to nonresidential properties, such as new roofs, HVAC, fire protection, and security systems. Items qualifying for Section 179 can also be written off 100 percent in the year acquired. A cost segregation study can identify all the building’s systems that could qualify for immediate expensing under the expanded bonus depreciation and Section 179 rules.

One note of caution, however: If you will be selling your building and acquiring another property in a tax-deferred exchange, the sale may be partially taxable as some items identified by the cost segregation study will not qualify for a tax-deferred exchange.

Is a Study Worth the Effort?

It is worth evaluating a cost segregation study on virtually any size commercial property, even those with a cost basis as low as $250,000. What’s more, it is never too late to perform a cost segregation study. If your business did not take advantage of these benefits in the year a property was initially purchased or constructed, you can still do a look-back study that could allow you to claim all of the prior years’ missed depreciation deductions in one year.

Of course, there are costs involved. To meet IRS requirements, you need a professional engineer to classify the various building components. And although depreciation might seem straightforward, the details can get complicated, so your CPA’s guidance is essential.

In the case of new construction, these costs can be mitigated somewhat if all those involved coordinate from the beginning to be sure they capture the relevant information up front, rather than having to go back and recreate it. Even for existing structures, however, most companies will find the benefits outweigh the costs, producing a significant tax benefit and increased cash flow.

Please contact Holbrook & Manter with any questions you may have on this topic. We would be happy to assist you.