Cost Segregation Studies
 
December 17, 2002
 

This article is intended to call your attention to recent changes in real estate depreciation laws that can be used to reduce taxes related to commercial real estate investments. The effects can be quite material on major projects. The result is achieved through the use of a “cost segregation” study that allocates depreciable assets on an aggressive, but realistic and permissive basis.

A cost segregation study provides an opportunity to increase your cash position in a commercial real estate investment. The Internal Revenue Code (the Code) provides a faster write-off (by means of the depreciation deduction) for commercial real property improvements that do not constitute structural components of a building than is provided for structural components. In general, the structural components must be depreciated over a period of 39 years (27.5 years for residential rental property) while the nonstructural components may be depreciated over periods ranging from five to 15 years. The object of a cost segregation study is to identify and classify those items of a building that are not structural components and, therefore, are eligible for the more rapid write-off for depreciation purposes. By insuring that otherwise eligible property is depreciated in five to 15 years, rather than 39 or 27.5 years, you will improve your cash position if the property generates sufficient taxable income to fully utilize the additional depreciation deduction for tax purposes.

In general, an item constitutes a structural component of a building if it relates to the operation and maintenance of the building. The factors to be considered include:

• Is the item capable of being moved, and has it in fact been moved?
• Is the item designed or constructed to remain permanently in place?
• Are there circumstances that tend to show the expected or intended length of affixation i.e., are there circumstances that show that the item may or will have to be moved?
• How substantial a job is removal of the item and how time-consuming is it? Is it “readily removable?"
• How much damage will the item sustain upon its removal?

What is the manner of affixation of the item to the land? For instance, medical equipment hook-ups, dedicated wiring, medical gas lines, closed circuit television, and similar specialized systems are generally considered to be nonstructural components of a building and may qualify for depreciation over five years.

Additionally, a cost segregation study may be used to identify land improvements (other than equipment) that are not considered to be structural components of a building and that are eligible for the faster depreciation write-off. For instance, improvements such as sidewalks, driveways, drainage facilities, fences, landscaping and shrubbery are considered nonstructural components and, in general, may be depreciated over a period of 15 years.

A cost segregation study may be performed for any commercial property placed in service after 1986, even if the year is closed for federal income tax purposes. For existing buildings, the reclassifying of a component of the building for depreciation purposes is a change of an accounting method that requires the prior consent of the Internal Revenue Service (the Service). The Service, however, has provided a procedure for obtaining an automatic consent in situations where the taxpayer has used an accounting method for at least two years that understates the depreciation the taxpayer is otherwise entitled to claim under the Code. Under this procedure, the depreciation that the taxpayer failed to deduct in the prior years may be deducted over a period of four years. If the additional write-off is less than $25,000, the taxpayer may elect to write it all off in the first year. Reclassification of property for depreciation purposes according to a cost segregation study falls within this automatic approval procedure.

In addition, a cost segregation study may be undertaken in connection with the construction of a new facility, or the acquisition, remodeling or expansion of an existing facility.

The cost segregation analysis should be performed by a competent engineer or other qualified person and must be fully supported by contemporaneous documentation of costs, associated plans, specifications, blueprints, etc. Due to the fees involved, a cost segregation study may not be cost effective for real property improvements costing less than $1 million. Additionally, the property should produce sufficient taxable income to fully utilize the additional depreciation for tax purposes over a period of four years. Improvements that have specialized equipment, wiring and systems are the best candidates for cost segregation.

For more information, contact Martin Murphy, toll free, at 888-688-8500.