Understanding the purpose of a cost segregation study

Property acquired or constructed by a taxpayer can be ‘depreciated’ (expensed) for tax purposes over its useful life. The IRS has specific guidelines as to the specific useful life of property.

There are different useful lives for different properties. For example, a commercial building has a useful life of 39.5 years. The cost of the building will therefore be expensed ratably over this term of years.

Other assets that are not a building or its structural components, such as moveable partitions, computer and phone systems, can be depreciated over a much shorter time frame – usually 5 or 7 years.

The tax laws in this area are very complex.  In many instances the useful life is determined based on the intended use by the taxpayer.  To determine the useful life contained as part of a building acquisition or construction the taxpayer will need to retain a outside company to prepare a professional engineering study (i.e., “Cost Segregation Study”).

A cost segregation study will provide the taxpayer with an allocation of the various components and useful lives included in a building.

What are the benefits of a cost segregation study?

 The depreciation of an asset by a taxpayer creates an annual tax savings for the benefit of this taxpayer. The shorter the life of an asset the more the value of the depreciation expense. A five year write off will provide much more ‘present value’ benefit of the depreciation than a 39.5 year write off.

A cost segregation study will provide the taxpayer with an allocation of the various components of a building acquired or constructed.

Here is an example:

A taxpayer acquires a building (not the land) for $2,000,000.  Without a cost segregation study, the taxpayer will depreciate this building over 39.5 years.  The annual depreciation expense will be $50,633.

A cost segregation study may determine that a portion of the cost this building included $300,000 of five-year assets.

The taxpayer will now depreciate a building costing $1,700,000 over 39.5 years and $300,000 of assets over 5 years.  The annual depreciation expense for the first five years will be $103,037.  After the fifth year the expense will $43,037.

The expense, overall, will be the same only now it is available to the taxpayer in the early years.  A significant ‘present value’ benefit.

Assets that are not part of a building or its structural components can also be expensed in the year of acquisition, with certain limitations.  This can be by using either/or Additional First Year Depreciation, Section 179, or Bonus Depreciation.

There are other benefits that many taxpayers are not aware of.  These benefits include:

  • Lower, or more accurate, insurance costs of a building and its components.
  • Lower, or more accurate, property tax costs. Property taxes are assessed based on costs and residual values.
  • The taxpayer will be able to write off dispositions of specific assets when they occur. A common example of this is when the taxpayer replaces the roof of a building. Without a segregated cost study, the taxpayer will have no ability to document and ‘write off’ the old roof and now must also capitalize the cost of this new roof while continuing to depreciate the old roof. Two roofs held on the books when only one exists.

Other considerations:

A typical cost segregation study can cost the taxpayer $5,000 to $10,000.  This fee can be much higher depending on the size and complexity of the building.

The rule-of-thumb benefit is that for every $1 million in building acquisition cost there should be a tax savings in the range of $40k -$50k.  This tax savings can have a very large range depending on facts and circumstances.  Many times, the company doing the cost segregation study will provide the taxpayer with an estimate of the anticipated tax savings before the work begins.

There have been a lot of abuses in this area with companies preparing these studies. There are companies that are not always qualified to do the work or may be overly aggressive in their allocations. The taxpayer must be careful and only hire companies that are competent and qualified.  The IRS will challenge the study if it seems unreasonable.