Cost segregation is the process of identifying and segregating the components of a building and its exterior land improvements into separate asset classes. This allows the segregated property to be depreciated over a faster recovery period and take advantage of accelerated depreciation methods available under §168 of the Internal Revenue Code, generally known as the Modified Accelerated Cost Recovery System (MACRS). This has become more important with recent tax legislation. The passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) contains a gradually declining set of tax rates. This means that deductions are worth more now, even without consideration of the time value of money, than they will be in the future. The result is that every $100,000 invested in a building that is classified as tangible personal property and depreciated over five years under the modified accelerated cost recovery system (MACRS) will produce a net present value (NPV) of deferred federal taxes of approximately $20,000--$18,000 for seven-year property. Every $100,000 invested in a building that is classified as land improvements and depreciated over 15 years under MACRS will produce a NPV of deferred federal taxes of approximately $11,000. State income taxes deferred will add up to an additional approximately $6,500, 6,000, and $3,500, respectively.
Cost segregation may be performed on any building purchased, constructed or renovated by the current owner as far back as January 1, 1987. Amended returns are now an option for a building placed in service up to three tax years prior to the current tax year. An automatic application for change in accounting method (Form 3115) is now also an option for properties placed into service during this time period. For property placed in service from four tax years prior all the way back to 1987, Form 3115 is the only option. Based on the Rev. Proc. 2002-19 released on March 14, 2002, the unclaimed allowable depreciation from all prior years may be recognized in full in the year of change-no matter how high the amount. Prior to the issuance of Rev. Proc. 2002-19, the unclaimed allowable depreciation was required to be recognized over a four-year period beginning with the year of change if the change was over $25,000.
Cost segregation applies to any type of building. It does not have to be a high profile or a highly specialized building. The more specialized, the greater the benefit, but even minimally-specialized buildings, such as warehouses, still benefit. Therefore, no building should be overlooked except for those placed in service by the current owner before January 1, 1987.
Cost segregation for constructed or renovated buildings may be performed in various ways. The most common type of cost segregation study, and the only method available for purchased existing buildings, is the engineering method where a qualified architect, construction engineer, or construction estimator generates asset takeoffs through blueprint analysis and then estimates the costs using nationally-recognized cost estimating procedures acceptable to the IRS. Other considerations are necessary as well in order to come to a complete and reasonable cost estimate.
In 1997, the landmark decision in Hospital Corporation of America, et al. v. Commissioner (109 TC 21 [1997]) (HCA) provided the guidance needed to produce valuable cost segregation studies. In HCA, the court established that if the asset would have qualified for the repealed investment tax credit (ITC) under §38, then it qualifies now to be segregated into §1245 tangible personal property. This includes electrical breaker, wiring, conduit, etc., and plumbing piping, etc., if the equipment these components serve qualifies for §1245 treatment and is specific to the business operation rather than to the operation or maintenance of the building.
Other criteria used to determine if an item qualifies for faster recovery and accelerated depreciation include whether a particular item is clearly decorative in nature as opposed to structural or integral to the building, or whether it is permanent in nature, i.e., if it can be easily moved or removed without substantially ruining the integrity of the building.
Examples of large cost items requiring segregation include electric, plumbing, concrete, masonry, lighting, paving, HVAC, millwork, telephone and network wiring, and much more. After proper identification and segregation of these costs, the remainder must remain classified with the building and be depreciated over 39 years. Therefore, study of the blueprints or the site itself is needed to properly segregate the qualifying costs in a way that maximizes the taxpayer's NPV benefit in a manner acceptable to the IRS.
Since most studies require the engineering method, the IRS requires the use of qualified architects, construction engineers, or construction estimators, and that a cost segregation study performed without adequate records to support the segregated costs will not be accepted. (See decision in favor of IRS against taxpayer for estimating their segregated costs based on cost segregation studies prepared on other buildings in Boddie-Noell Enterprises, Inc. v. U.S. (78 AFTR 2d 96-7134, 11/04/1996, Code Sec(s) 6402).) Due to this engineering requirement, most CPAs are generally not equipped to perform cost segregation studies in-house and must out-source in order to provide this service to their clients. We work very closely with CPAs in order to help them provide this service to their clients.
The advantages of a cost segregation study are clear. Most taxpayers, when they buy, construct or improve a facility, depreciate the entire cost, including the land improvements and components using straight line over 39 years because the information necessary to identify and segregate qualifying costs is not available. Occasionally, certain costs are segregated by the taxpayer when such information is available, however, most qualifying segregated costs are never accelerated because without comprehensive analysis of blueprints, it is impossible to reasonably segregate these qualifying costs.
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