Introduction to Cost Segregation

A compelling tax savings opportunity
for real estate owners

We can typically assist in recovering at 10 cents or more for every dollar you spend on new construction or a purchased building using IRS-compliant accelerated tax depreciation.

A cost segregation study carefully breaks down your construction or acquisition costs and allocates them to specific categories - maximizing accelerated depreciation for qualifying personal property. The shorter the depreciation period, the greater your tax savings. This study could also be used to provide the basis for your property records system. In addition, certain construction costs do not add to value and should be excluded from the property tax basis. These may involve overtime, demolition, etc.

Although the optimal time to begin a cost segregation study is when plans to build, remodel, or expand a building are first drafted, eligibility extends to:

The first step is the segregation of the project costs into specific asset groups. The costs to be segregated include the actual direct costs of construction or acquisition and the indirect or “soft costs” (i.e. legal, architectural, engineering fees, appraisals, construction management, etc.) The second step is categorizing the assets based on the appropriate depreciable lives for income tax purposes.

By identifying, segregating, and reclassifying costs related to 5, 7, 15, and 20 year property from the 27.5 or 39 real property categories, such property can be depreciated over a much shorter time frame. In addition, the 5, 7, 10, 15, and 20 year property classes are depreciated using accelerated methods, which further increase the deductions in early years.

Critical to establishing this significant cash benefit is a detailed engineering analysis. We provide complete cost analysis and supporting documentation. Our engineers understand accounting and tax codes as well. They perform quantity take-offs from construction drawings or available data for purchased buildings. The key to withstanding IRS scrutiny is a thorough application of engineering standards and our prior successful negotiations with the Treasury. We do not merely rely on broad percentage allocations or contractors lumped costs.

If you depreciate newly constructed or purchased buildings over a 39 year tax life (27.5 years for residential rental real estate), you have left cash in the building. You can recover on average of 10 cents of every dollar in the building account by accelerating tax depreciation from shorter lived personal property and site improvements.

The primary authority for this segregation of building costs is Revenue Procedure (Rev. Proc.) 87-57, 1987-2CB687, which provides comprehensive instructions and depreciation rate tables for computing depreciation available under Code Sec. 168, as amended by Act Sec. 201(a) of The Tax Reform Act of 1986. These depreciation tables are known as MACRS, Modified Accelerated Cost Recovery System.

Structural components of a building, as defined in Regulations Section 1.48-1(E)(2), include such items as walls, partitions, floors, HVAC, plumbing and plumbing fixtures, etc. and other components relating to the operation or maintenance of the building. Excluded from the definition is machinery or processing materials or foodstuffs.

In contrast to the above definition, Code Section 148-1(C) defines tangible personal property as “any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures.…” Tangible property includes all costs (assets) that are necessary/accessory to the operations of the business. Examples include:

Special rules incorporated from Rev. Proc. 83-35, sections 2.02 (iii) and (iv) define Asset Guideline class 00.3, Land Improvements, as “other tangible property”. Thus, costs for site improvements should be removed from construction or acquisition costs and put into this account.

In order to claim underreported depreciation for prior years, the taxpayer may request an automatic change of accounting method. The authority for this claim is Revenue Procedure 99-49. The missed depreciation may be claimed over the four ensuing years (Section 481 adjustment). The cost segregation analysis can be used for buildings placed in service as far back as 1987, even if the year is closed for tax purposes.

Two court cases support the determination of personal property apart from structural components. The most recent is H.E. Butt Grocery Company (2000), which reinforced the claim of added depreciation based upon a cost segregation study. The second and most critical is Hospital Corporation of America v. Commissioner (1997), which provided clear evidence of what the courts consider tangible personal property versus structural components.