You must be knowing; cost segregation is a tax planning tool that helps in increasing the cash flow and reducing the state and federal income taxes. But should you opt for a cost segregation study? This blog will give you an insight on what cost segregation is and help you understand if you should opt for it.
Should you opt for a cost segregation study?
If you own a business or if you had acquired, constructed, or improved a building in recent times or in the previous years you can certainly opt for a cost segregation study. It is an IRS-defined approach and the most accurate depreciation methodology for assets acquired or constructed after 1986. The study identifies the cost of a building. It takes tangible personal properties more into consideration rather than real properties. This accelerates depreciation deductions, which in turn reduces taxes and increases the cash flow.
Cost Segregation: The basics
As per the IRS rules commercial buildings can be depreciated over 39 years and residential properties over a 271/2-year time period. Most of the time a building’s structural component is only depreciated i.e. an elevator, wall, window, etc. along with the property. Business personal properties such as plant and machinery, furniture are all depreciated over a five or a seven-year period. When it comes to land improvements, parking lots, fences are all depreciated over a fifteen-year period.
Identifying the thin line between real and business personal property
Many businesses allocate most of the construction costs to real properties missing the opportunity of allocating the same on short-lived business personal properties or land improvements. Components that seem to be a part of the building can be classified under personal properties. Say for example decorative lighting, a removable wall, etc.
Similarly, few components that are treated as real property can be classified as business personal property if they help in the functioning of a business rather than just a structure. Say, for example, a plumbing installation that is used for the functioning of an equipment.
Cost segregation, a valuable investment?
To make it easy let us understand the whole concept with a simple example. Say you have acquired a commercial property worth five million dollars and is allocated to a thirty-nine-year real property. You can claim $123,050 in year one as depreciation deductions i.e.2.461 percent of five million dollars.
Now that a cost segregation study comes into play, it shows you can allocate one million dollars in cost to the five-year property. The calculation goes as follows, four million dollars * 2.461 percent + twenty percent of one million dollars. This equals to $298,440, increasing your first-year deduction.
Finally, a note of caution
Cost segregation studies are considered for property tax and sales tax purposes but there is one thing you should remember. Not all properties are treated the same when it comes to income tax or property tax. Say for example your state has business personal property tax and you reclassify few components as personal property for income tax purpose with the help of a cost segregation study but if your state law classifies them under real property for taxation you will be taxed twice that is one time as personal property and the other time as real property. Hence, make sure you classify the costs separately for income tax and separately for property tax purposes.
Final thoughts
Cost segregation studies have a lot of advantages but not every business can benefit. To find out if a cost segregation study can yield you benefits have a word with a property tax consultant, get a property analysis done, and get to know how much you could save.
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