Real estate investors and business owners can increase cash flow and decrease tax liability through a process using a cost segregation study, a powerful tool that allows for the classification of real property into different depreciation categories that can provide immediate and substantial benefits. But you may be wondering – how much does a Cost Segregation Study cost?
When companies plan construction or purchase of a building, or if a business owner recently has completed renovations on a building they own or lease, a cost segregation study can separate assets that allows the taxpayer to depreciate the property over much shorter time periods than the traditional 39-year schedule used for commercial properties or the 27.5 years for residential. Commercial real estate owners or business owners can pay for a specialized engineering report, known as a cost segregation study, that segregates all the assets of the property into four categories: personal property, land improvements, building components, and land.
By separating those assets, taxpayers can use a shortened depreciation schedule for some components of five to 15 years. Mostly for those components classified as personal property and land improvement, the faster depreciation allows the taxpayer to benefit from a quick, and often significant, increase in cash flow; a decrease in tax liability; an ability to defer taxes, and a chance to reclaim past depreciation deductions that may have been missed. The result is a lower income tax rate for a property owner by writing off assets at a more accelerated rate than traditional straight depreciation limits, which increases their business’s cash flow and profitability.
How much does a Cost Segregation Study cost?
It’s important to have a proper engineering report completed that documents how the assets are separated and eligible for accelerated depreciation. These cost segregation studies can cost anywhere from $10,000 to $25,000 on average, but often they can generate significant savings of as much as $500,000, depending on the commercial property and assets involved, according to the Journal of Accountancy.
Some firms bill time and costs, and some bill a percentage of the tax savings identified. Some factors affecting the cost of the study include the property’s location, whether it is new construction or existing, and if residential or nonresidential. A cost-benefit analysis can help determine if a cost segregation study is worth it for your business.
Time value of money
The idea behind a cost segregation study is to segregate all of your property’s costs into an appropriate property class that can provide a more advantageous calculation of depreciation deductions. Basically, you’re separating out what’s part of the permanent building and what’s part of the business.
The typical depreciation schedule used after a commercial property is purchased is based on 39 years. But if all the components of the property are separated into those four categories mentioned previously, as much as 40% of the building’s components may be considered differently under IRS rules. A physical commercial building, for example, normally is depreciated over 39 years, but some other components could be depreciated over five, seven, or maybe 15 years once properly segregated and documented in the cost segregation study.
Some components that can be reclassified for more rapid depreciation include flooring, appliances, counters, cabinets, landscaping, signage, lighting, parking lots, and some electrical wiring. A cost segregation study can identify these and other components of a property that have a shorter life and identify them for quicker depreciation.
These front-loaded depreciation deductions ultimately will be of greater value to the taxpayer under a shorter schedule than over the longer period typically used which results in slower depreciation. That’s because the quicker depreciation takes advantage of the time value of money, meaning the taxpayer’s benefit from the deduction is greater and more valuable today than it would be 30 years from now.
Benefits of possible write-offs
If an investor or business owner purchases or builds a new building, the quicker depreciation deductions identified under the cost segregation study will lead to possible write-offs, which can increase cash flow. The study also effectively segregates the different components of a building into four categories, allowing them to be depreciated separately and setting up possible future write-offs if components need replacing.
For example, let’s say a cost segregation study shows an initial value of a roof to be $500,000. Two years later, the owner has to replace the roof, now with an adjusted tax basis of $480,000. That means the taxpayer could deduct a $480,000 loss when replacing the roof after the cost segregation study, something that would not have been possible under the longer-term depreciation schedule.
Generally, when components of a building are identified as personal property, they can be depreciated more quickly using a five- to seven-year period. These are things like furniture, flooring, some fixtures, and window treatments. Components classified as land improvements have a somewhat longer useful life, up to 15 years, and also can use an accelerated depreciation method. These are things like sidewalks, fences, and parking lots.
The basic idea, although not the definitive rule, is if the property can be moved, it might qualify for a quicker depreciation deduction. It’s the difference, say, between a separate storage building added on a property that has a concrete floor versus one with a wooden floor.
Not all cost segregation studies are equal
A cost segregation study can be completed years after a building purchase or improvement. IRS rules allow a taxpayer to claim “catch-up” depreciation deductions in a single tax year for prior years missed if depreciation schedules are changed, meaning there could be immediate tax benefits from real estate deals completed 10 years earlier.
One problem some taxpayers encounter with cost segregation studies is not properly classifying property and documenting the distinction. This is why it’s so important to obtain a study from a reputable, experienced professional who understands the complexities of IRS rules and court rulings that have outlined the proper practices for segregating components. For example, the U.S. Treasury Department has defined certain tangible personal property, which would be eligible for shorter depreciation schedules, as “all property (other than structural components) which is contained in or attached to a building.” These would be items such as printing presses, transportation and office equipment, appliances, and display racks, according to the Journal of Accountancy.