The Value of a Cost Segregation Study When Depreciating Property
If a building is used in a business, the owner can usually take deductions on their tax return based on the cost of the building, thereby reducing the amount of income tax the owner has to pay. In effect, by giving the owner these tax deductions, the government is giving the owner money to help defray the cost of the building.
The Depreciable Life of Property: Personal Property vs. Real Property
But, the business owner cannot deduct the whole building all at once. If it’s a commercial building, the tax deductions occur over a 39-year period. Or, if it’s a residential rental house, the owner’s deductions happen over 27.5 years. They call that the depreciable life.
In contrast to a building, when a business buys furniture or equipment and puts them in service, the law allows the business to take depreciation deductions for them over a relatively short period, such as 5 or 7 years.
Something you may not know is that certain items within the building, which sometimes look like part of the building to an average person, can be considered as NOT part of the building? If something is not a structural component of the building, it might qualify for a shorter 5- to 7-year depreciable life, instead of those 39- or 27.5-year lives.
Here is a list of examples of items that may qualify:
- Certain types of lighting
- Certain cabinets or countertops
- Furniture and equipment
- Shelving that’s not built in
- Certain floor coverings (like carpet that’s not permanently attached)
- Certain electrical wiring
- Certain special plumbing
- And more…
It can sometimes be tricky to separate this “personal property” (items above) from the “real property” (the building itself). The process is normally called a “cost segregation study”. Many times, it takes a team of professionals (like Tanner, LLC) to conduct a proper cost segregation study to make sure it’s done in a way that’s more likely to stand up under IRS scrutiny.
Cost Segregation in Action
The following scenarios help demonstrate the value of segregating costs when it comes to depreciating your property:
Scenario 1 – No cost segregation study
Your company buys a commercial building costing $1,000,000 and puts it in service on January 1, 2011. You don’t try to segregate costs and you allocate the entire purchase price to the building. Your depreciation deduction for 2011 would be $24,610, which could save you taxes in 2011 of $8,367 (assuming a 34% tax rate).
Scenario 2 – With cost segregation study
Same facts as above, but you decide to do a cost segregation study, which reveals that $100,000 of the total purchase price can reasonably be classified as 7-year personal property. Your depreciation deduction for 2011 would be $36,439 ($14,290 on the $100,000 of personal property plus $22,149 on the remaining $900,000 building), which could save you taxes in 2011 of $12,389 (same 34% tax rate).
The tax savings for 2011 under Scenario 2 is 48% higher than under Scenario 1. And, there is a provision in the federal law right now under Internal Revenue Code Section 168(k). It’s called bonus depreciation. If all the criteria are met, you may be able to deduct ALL of the $100,000 of personal property in 2011. Note that the 100% bonus depreciation is only good through 2011. In 2012, it switches to 50%, which is still a great benefit. After 2012, there is no provision for bonus depreciation under current law.
Scenario 3 – With cost segregation study and Sec. 168(k) bonus depreciation
Same facts and assumptions as Scenario 2, but you take 100% bonus depreciation on the personal property. Your overall depreciation deduction for 2011 would be $122,149! At a 34% tax rate, this could save you taxes in 2011 of $45,195. That’s 540% better than Scenario 1
There exists another code section (Section 179) under which you may be able to take a huge write off in the year you put business personal property in service. Of course, with beneficial tax rules, there are always limitations and fine print to read. The above discussion has been about federal tax laws. State tax laws can be different.
Also, another thing to consider is that by depreciating property faster, you don’t increase the overall depreciation deductions over the lifespan of the asset; rather, you are simply claiming more of the deductions in the early years. But if you believe that money is worth more now than in the future, then deductions taken sooner may be better than later.