Cost segregation is a technique for assigning the values of property components to a time element for tax purposes. The process involves identifying a subsequent component, its age-life value and remaining economic life, then separating it from the sum total of the property improvements.
Because different improvements, such as the roof rather than a HVAC system, have different depreciation rates for tax purposes you may be accelerating the amount of the depreciation you're able to take towards the front end of your investment, which can be beneficial for tax purposes, cash-flow and investor relations.
Why use cost segregation?
Cost segregation allows you to accelerate depreciation on portions of your building and site by identifying them as personal property. By accelerating depreciation, you lessen your tax burden and put more money in your pocket. As an example, if you are in the 37% tax bracket, and your cost segregation study gives you an additional $100,000 in depreciation for your first year, that could be $37,000 in extra cash flow.
Recent tax law changes under the Tax Cuts and Jobs Act of 2017 (TCJA) have given an additional boost to cost segregation.
Bonus depreciation (the federal tax incentive that allows a business to immediately deduct a large percentage of the purchase price of eligible assets) was increased from 50% to 100%, essentially allowing real estate investors to immediately expense anything less than 20 year property. A cost segregation study produced by Madison SPECS will separate any costs that qualify under the new bonus depreciation rules.
A Cost Segregation study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27 ½ or 39 years. The primary goal of a Cost Segregation study is to identify all property-related costs that can be depreciated over 5, 7 and 15 years.
A Cost Segregation study might be thought of as an interest free loan in that it front-loads the depreciation expense deduction a property would otherwise receive over 27.5 or 39 years.
Cost Segregation studies free up capital by accelerating the depreciation of personal property (§ 1245) and Qualified Improvement Property (QIP) as well as identifying various expensing opportunities associated with commercial real estate. The accelerated time frame is typically 5, 7 and 15 years rather than 27.5 or 39 years for the building (§ 1250).
The ideal time to have a Cost Segregation service conducted is during the year you are purchasing, remodeling or constructing a commercial property. If you were unable to perform a study when the building was placed-in-service, we might still perform a lookback study which will correct your depreciation schedule going forward and generate a catch up in missed depreciation (§ 481(a) adjustment).
Depending on when your building was placed into service, you may be eligible to only amend your previously filed tax return. If it has been more than one year of your tax returns having been filed, it is our understanding that you must file form 3115 for a section 481(a) adjustment otherwise known as change of accounting method.
Any depreciation that should have been taken previously with a cost segregation study done from the time the building was placed into service can be recaptured by this method. If your tax advisor is not familiar with filing form 3115, we have accountants that we work with who can fill out this form for an additional fee.
Depending on tax law for the year your building was placed into service, you may qualify for bonus depreciation. If this is a new building purchased or constructed in 2018 and through the end of 2022, all accelerated values will qualify for bonus depreciation. We recommend you consult with your tax advisor to discuss bonus depreciation related to your situation.
The benefits of a Cost Segregation services are typically measured in terms of:
Increased cash flow generated in earlier years; and the greatest benefit from a Cost Segregation study.
Increased cash flow generated in earlier years; and the greatest benefit from a Cost Segregation study.
Net present value (NPV) of receiving depreciation expense deductions Net present value (NPV) of receiving depreciation expense deductions earlier rather than prorated over the life of the property.
Cost segregation can be beneficial for commercial real estate properties, as it may allow the owner to take larger depreciation deductions upfront, in the early years of ownership, which can result in a lower tax liability. However, it's important to note that a cost segregation study requires a in-depth analysis of the property and its components, and may not be appropriate for all properties or taxpayers based on your current situation or needs.
Consult with a tax professional or financial advisor if you are considering cost segregation for a commercial real estate property, to determine whether cost segregation is appropriate for your situation and assist you with the process.
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