Cost Segregation

Hand poised over a cost segregation blueprint

Informed tax planning increases your deductions so that you have the lowest liability possible. Good tax planning may also involve claiming certain deductions as early as you can. Through a process called a “cost segregation study,” your small business may be able to expedite one of its most common tax deductions: depreciation.

Cost Segregation Studies

Cost segregation studies allow you to accelerate the availability of your depreciation deductions for certain property by taking advantage of a quirk in the IRS’s depreciation rules. Taxpayers commonly assume that they must depreciate all of their business’s property throughout the course of its useful life based on a single classification; in other words, they typically assume that their business property must fall within a single asset class for tax purposes. According to the tax law however, you must depreciate your property based on the IRS’s pre-established charts, and these charts mandate specific depreciation rules for different types of asset classes. The charts differentiate between depreciation treatment for real property — such as land, improvements to land, fixtures, etc. — and personal property, such as furniture and movable equipment.

In general, the IRS requires that you deduct non-residential real property depreciation by using the straight-line method over a 39-year period. Personal property, on the other hand, may be depreciated over 7, 5 or even 3 years with the option of using an accelerated depreciation method such as the double-declining balance method. As an example, if you were to purchase 2 assets of equal price, both land and movable equipment, the IRS would limit your depreciation deductions to much smaller amounts for the land over a long period. Meanwhile, you could claim higher deductions over a shorter period of time for the equipment. As a result, it greatly behooves your company to capitalize on the IRS’s treatment of personal property assets to prevent property from being classed as real property whenever possible.

Participate in a Cost Segregation Study

Cost segregation studies, therefore, are intended to ensure that you are optimizing the timing of your depreciation deductions. They are designed to increase your overall financial position by giving you access to capital more rapidly. Cost segregation studies ultimately follow the accepted principle in business that time equals money.

To conduct such a study, you need to hire a qualified professional to examine your property and make sure that it is correctly categorized by asset class. These studies can be done during the construction of, after you acquire, or even while you are presently using your property.

A qualified professional in this area is someone who possesses knowledge of the construction process, engineering process, and relevant tax law in order to conduct the study properly. At the end of the study, your hire should provide a comprehensive report which substantiates all of the study’s findings.

Highlights of the report will be things like:

  • An explanation of the method used to classify assets and their associated costs
  • An explanation of the expert’s legal analysis
  • A thorough organization of the existing assets
  • A reconciliation of the total allocated costs to total actual costs
  • An explanation of how indirect costs are dealt with

Act On Findings

If your cost segregation study suggest that you may treat certain assets as personal property rather than real property, you should alter your depreciation method to obtain an accelerated tax deduction. To do this properly, you have to file a Form 3115, Application for Change in Accounting Method, with the IRS. There is an option to ask for an automatic consent from the IRS to the change.

Importantly, you shouldn’t attempt to amend prior returns based on trying to apply a cost segregation study retroactively. The IRS has generally struck down such attempts except in a number of rare instances.

Precautions For Cost Segregation

Though a cost segregation study has the potential to be an immensely beneficial part of your tax planning strategy, there are still several things you must consider before you undertake such a study.

The existing case law pertaining to cost segregation studies does not present a clear picture as to precisely how to classify a given piece of property as either real or personal. Hence, IRS audits that arise from cost segregation studies are more likely to involve intensive inquiries into the facts of the case. In view of this, it’s very important that those contemplating a cost segregation study go the extra mile and procure the most qualified help that they possibly can to assist with this endeavor. In other words, taxpayers who take excessive cost-cutting measures in the beginning run the risk of paying much more in the distant future.

What’s more, the U.S. Tax Court has ruled that tangible personal property must be depreciated in the same manner as real property if it be purchased together with the real property as a bundle. This ruling by the Tax Court is highly significant and should be referenced prior to undertaking a cost segregation study. Only after you weigh all of your options should you commit to this type of study given the costs and risks involved.

Give us a call at 425-483-6600 to learn more about cost segregation from one of our experienced CPAs!


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Image credit: Brad Wang