Cost segregation is an effective means of accelerating tax depreciation deductions for property investors. Properly classifying investments made in a building between real and personal property allows investors to claim a substantial reduction in current income tax liabilities and may increase cash flow. The results can be very substantial and realized immediately.
Cost segregation rules are complicated. In brief, they allow a taxpayer to separately depreciate components of a building that are unrelated to its “maintenance and operation” over shortened depreciation periods. In addition, these deductions are computed using an accelerated depreciation method. This allows costs to be recovered more quickly than under the “straight-line” method.
For tax purposes, the straight-line method generally depreciates residential rental real estate properties over 27.5 years and commercial real estate properties over 39 years. However, under IRS cost segregation guidelines, a significant portion of a building’s cost can be depreciated over much shorter periods—usually five or seven years!
Many types of building components can qualify for the shortened depreciation period and accelerated depreciation method. It would be impossible to list them all, but common examples include molding, millwork and other decorative elements, carpeting, wall coverings, partitions, window treatments, counters, cabinets, shelving, special lighting, specialized machinery and equipment and the costs of plumbing and electrical allocable to such equipment.
In addition, certain land improvements located outside of a building may be depreciated over 15 years. Land improvements include items such as landscaping, fences, sidewalks, curbs, parking lots, lighting, utilities, signs, swimming pools, tennis courts and playgrounds.
When these nonstructural components are segregated and reclassified as personal property, substantial savings may be realized, depending on the size of the building and the nature of the personal property. As much as 50% of a building’s components may be reclassified into a shorter recovery period. Whether your property is under construction, being remodeled or purchased, there are valuable tax deductions hidden in your property.
The Internal Revenue Service reinstated a form of component depreciation in 1999 and has helped investors with guidelines to determine real and personal property. When properly implemented, cost segregation is an attractive tax saving tool for reducing taxes, increasing cash flow and improving the rate of return on investment.
How to Determine if a Cost Segregation Study is Necessary
A cost segregation study is an engineering-based approach to identifying assets within a building that can be reclassified into a much shorter depreciation class than the building itself. A cost segregation study should be conducted by a qualified engineer, as only engineering-based studies will likely withstand IRS scrutiny. To determine if a study is appropriate, the following circumstances would apply:
- Is the cost of your building at least $500,000?
- Have you purchased, constructed or renovated any property since 1987?
- Do you plan on retaining the property for the next few years?
- Do you have net income that is being taxed?
If you answered “yes” to these questions, then cost segregation could be a valuable tax benefit for you. Your tax consultant can assist you in determining if cost segregation is right for you.
Cost Segregation: An Example of the Benefits
Below, the same amount is depreciated over different time intervals. The “original” column shows the building cost depreciated using the straight-line method (39 years). The “segregated” column carves the land improvements and personal property from the building cost and depreciates them over shorter periods. The result is the same amount depreciated over different amounts of time.
|
Purchase Date October 1
|
Original
|
Segregated
|
|
Building Cost – 39 year
|
900,000
|
650,000
|
|
Land Improvements – 15 year
|
110,000
|
|
|
Personal Property – 5 year
|
_________
|
140,000
|
|
Total Recovery Property
|
900,000
|
900,000
|
The benefit of doing the above cost segregation is a tax deferral of $57,455 which may result in additional taxes when the building is sold. However, your current cash funds increase by this amount.
|
Year
|
Total Original Depreciation
|
Total Segmented Depreciation
|
Additional Depreciation
|
Total Taxes Deferred
|
|
2009
|
10,593
|
40,133
|
29,540
|
12,112
|
|
2010
|
23,076
|
70,306
|
47,230
|
19,364
|
|
2011
|
23,076
|
51,999
|
28,923
|
11,858
|
|
2012
|
23,076
|
40,713
|
17,637
|
7,231
|
|
2013
|
23,076
|
39,882
|
16,806
|
6,890
|
|
Assumes 35% Federal and 6% state income taxes, for a total of 40%.
|
140,136
|
57,455
|
||
If you would like any further information regarding this issue as well as any other tax related issue, please contact Henssler Financial’s Tax Experts at 770-429-9166 or experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
