September 1, 2015
What you Need to Know About Cost Segregation Studies for Commercial Real Estate
If you own virtually any kind of new construction or existing commercial real estate — housing, retail, industrial, institutional, health care, etc. — you may be able to realize tax and cash flow benefits that can come from conducting a cost segregation study.
As an owner, you are already taking advantage of depreciation for tax purposes. For instance, if you own a $10 million building, you can depreciate that asset and take an annual federal tax deduction of that value over 39 years.
However, the depreciation benefit does not reflect the reality of the situation, which is that certain assets within that building depreciate at a faster rate than others and often need to be replaced before 39 years.
A single building consists of a lot of parts: doors, window and roofs, plumbing and electrical and HVAC systems and a host of other components. These components have various useful lives, and in many cases, these useful lives are less than 39 years. Property owners who commission cost segregation studies ask cost segregation specialists — consisting of a team of engineers — to maximize their tax benefits by identifying, classifying and segregating these various assets that make up the building. The goal is to be able to claim useful lives for depreciation of five, seven or 15 years on certain component parts of the building rather than defaulting to 39 years for the entire building. Furthermore, the cost segregation report can be used as a tool to identify the value of component parts of the building if they are replaced. The remaining net book value of a replaced component part can be taken as a deduction immediately. This acceleration of the tax deduction for depreciation lets your company put refund cash in your pocket that you can use to reinvest.
As an example of the possible effectiveness of a cost segregation study, one real estate owner traditionally paid about $900,000 in annual income taxes. The first year of his company’s study resulted in a tax savings of around $800,000. That is pretty significant.
Here are the things you need to know about commissioning a cost segregation study.
- Advisability. Most building owners can benefit from cost segregation and accelerated depreciation, but that doesn’t mean everyone can. If you intend to buy and resell quickly, the tax benefit might not cover the cost of conducting the study. But for investors whose strategy is to hold on to property, it almost always makes sense. You might find that the immediate tax savings is significant enough to fund the down payment of your next real estate venture.
- Process. Your accountant can get the process started with a phone call. The engineering experts conducting the cost segregation study will initiate a site review and follow up with a report that will include court cases and IRS arbitration that set precedent for the depreciation claims made. Your accountant will file a Form 3115, Application for Change in Accounting Method, and this is automatically accepted by the IRS.
- Cost. The cost can vary depending on the size and complexity of the job and other factors, but most cost segregation firms will charge a fee in the range of $5,000 to $25,000 for the visit and report.
- Timing. The site visit by the engineer can usually be completed in less than a day, and your report should be ready in a few weeks but could take longer for a new construction project.
- Grandfathered benefit. As an added advantage, you can even get a segregation study conducted on a building you have owned for several years — and collect the accelerated depreciation benefits you have missed for all of those years.
Ask your accountant if you may be able to benefit from a cost segregation study.
James Jenco is a CPA at Wiss & Company LLC and performs audits, reviews and initiates cost segregation studies on behalf of commercial real estate clients. Contact him at firstname.lastname@example.org.