Cost Segregation

In order to calculate depreciation for federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property is typically separated into individual components or asset groups having the same recovery periods and placed-in-service dates to properly compute depreciation. When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to "segregate" or "allocate" costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture and fixtures, etc.). This type of analysis is generally called a "cost segregation study," "cost segregation analysis," or "cost allocation study."

In recent years, an increasing number of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods (including bonus depreciation and Internal Revenue Code (IRC) § 179 deduction) for computing depreciation deductions.

Cost segregation studies are most commonly prepared for the allocation or reallocation of building costs to tangible personal property. A building, termed "§ 1250 property", is generally non-residential real property (39-year) or residential rental property (27.5-year) property eligible for straight-line depreciation. Equipment, furniture and fixtures, termed "§ 1245 property", are tangible personal property. Tangible personal property has a shorter recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance, bonus depreciation and § 179 deduction). Therefore, a faster depreciation write-off (and tax benefit) can be obtained by allocating property costs to § 1245 property.

The following example illustrates the tax benefits of a cost segregation study. In general, a turnkey construction project includes elements of tangible personal property (e.g., phone system, computer system, process piping, storage tanks, etc.). It is relatively easy to identify these items as § 1245 property and allocate a portion of the total project costs to them. However, a cost segregation study may also report certain building occupancy items (e.g., carpeting, wall coverings, partitions, millwork, lighting fixtures) as § 1245 property that would have likely been classified or grouped under § 1250 property without the completion of a cost segregation study. These items may or may not constitute as qualifying § 1245 property depending on the particular facts and circumstances for which the project was designed.

Tax Muscle can coordinate a cost segregation study for your business to determine the extent to which you can reallocate costs from § 1250 property to § 1245 property. Depending on the aggregate costs that can be reallocated to § 1245 property, the tax savings from conducting the study can be significant.