Tax issues Investment Analysis

The Benefits of Cost-Segregation Studies

By Mark Vorkapich |

When a commercial property is purchased or constructed, a building asset is created and the dollars are entered into a fixed-asset system as 39- or 27.5-year property. Using the straight-line method, owners can take portions of the purchase as taxable income deductions each year of the schedule. Cost-segregation studies, which analyze the components that make up the building and assign these various components with recovery periods, can provide property owners with distinct tax advantages over the straight-line depreciation method.

Cost segregation is a process in which detailed entries are made in a fixed-asset system for all long- and short-life property. For instance, certain aspects of the property may be assigned a three-, five-, seven-, or 15-year tax life. These shorter lives are depreciated at an accelerated rate that dramatically increases taxpayers’ federal tax deductions. The impact of cost-segregation studies can be significant.

Property Analysis Example
The best way to illustrate the effects of cost segregation is to compare a property with and without a study. For example, a taxpayer purchases a strip mall for $1.3 million, excluding land and personal property. If no cost-segregation study is performed, the taxpayer enters the cost into the fixed-asset system as 39-year property. After the first five years, the taxpayer has accumulated $154,622 in depreciation expenses. However, consider the same property using cost segregation. After thorough engineering analysis combined with an understanding of what qualifies as short-life property as defined by Internal Revenue Code Section 1245, the strip mall is reclassified into five-year ($260,524), 15-year ($348,590), and 39-year ($718,457) property. After the first five years, the taxpayer has a total of $460,545 in accumulated depreciation expense.

The obvious difference is that the taxpayer has increased the accumulated depreciation expense by $305,000. With a cost-segregation study, the taxpayer has taken the majority of his depreciation up front and realizes that a dollar saved in the first five years is worth more than the same dollar in 16 years. As a result, the taxpayer has a net present value savings of almost $100,000.

The distinction between what qualifies as short- and long-life property has been shaped and reshaped during the last 20 years by court cases, private letter rulings, and Internal Revenue Service publications. With these ongoing changes, commercial property owners clearly can benefit from a properly documented cost-segregation study.