Many taxpayers and even their advisors may be unaware that recent tax code changes now provide for an accelerated depreciation deduction beyond that which is included in IRC sections 168, 179, and 1400. By using a technique called cost segregation, you can take advantage of these changes on behalf of your clients. The technique provides benefits in the areas of income tax, property tax, insurance, and more. Since cost segregation is based on depreciation, let’s first review how depreciation works.
Depreciation is the accounting process of allocating and deducting the cost of an asset over a period of years, a time known as the recovery period, which is set by the Internal Revenue Service. Non-residential real estate is depreciated over a 39-year period, residential rental real estate over a 27.5-year period, and personal property is depreciated using a 20-, 15-, 10-, seven-, five-, or three-year time frame. As this depreciation deduction is taken each year, the income tax basis of the property is reduced by an amount equal to the depreciation taken. For instance, if a taxpayer bought a building as an investment for $100,000 and sold it 12 months and one day later for $150,000, the gain of $50,000 would be a capital gain. If $2,564 were taken as depreciation, the tax basis for the building would have been reduced to $97,436 ($100,000 -$2,564). This would create a gain of $52,564 ($150,000 -$97,436). So each year the basis is reduced by the amount of depreciation taken.
The Internal Revenue Code contains several sections which provide additional tax benefits. Section 179 allows taxpayers to elect to deduct the cost of certain types of property on their income taxes as an expense, rather than requiring the property to be capitalized and depreciated. This property is generally limited to tangible, depreciable, personal property which is acquired for use in the active conduct of a trade or business.
Section 168 is part of the Jobs and Growth Reconciliation Tax Act of 2003 and increased the amount of bonus depreciation available to 50% for qualifying property acquired after May 5, 2003 and placed in service before January 1, 2005.
Section 1400L provided a similar benefit for qualifying property used by a business in the New York Liberty Zone.
Section 1400N, as enacted by the Gulf Opportunity Zone Act of 2005, provided additional tax relief for qualifying property acquired after August 28, 2005 and before December 31, 2007. Code section 1400N, or “GO Zone” as it is nicknamed, was made available for residential rental and nonresidential real property in areas hit by Hurricanes Katrina, Rita, or Wilma.
Cost Segregation Explained
Cost segregation is a process which allows certain items to be “reclassified” as tangible personal property and deducted over a much shorter period of time than would otherwise be the case. Properly reclassifying items can be complicated and is a primary reason why you should engage a qualified firm to do the analysis. Cost segregation is an engineering function and, as such, can get very meticulous. Generally, property can be classified into four primary categories: tangible personal property; land improvements; buildings; and land. Land Improvements can include items such as fences, sidewalks, docks, etc. Land, of course, cannot be depreciated, so the lower the land value the better.
Distinguishing between tangible personal property and the structural components of a building is a point of significant controversy. Because of this, I’ve included the IRS’s definition of tangible personal property:
“…’tangible personal property’ means any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures).”
This same subsection of the IRC states that “tangible personal property” includes “…all property (other than structural components) which is contained in or attached to a building.” Thus, such property as production machinery, printing presses, transportation and office equipment, refrigerators, grocery counters, testing equipment, display racks and shelves, and neon and other signs, which is contained in or attached to a building constitutes tangible personal property for purposes of the credit allowed by section 38. Furthermore, all property that is in the nature of machinery (other than structural components of the building or other inherently permanent structure) shall be considered tangible personal property even though located outside a building. Thus, for example, a gasoline pump, hydraulic car lift, or automatic vending machine, although annexed to the ground, shall be considered tangible personal property.
Clearly some items can easily be reclassified and then depreciated over a shorter time frame. Cost segregation will identify these items, allowing for accelerated depreciation. In the 1997 landmark court case, Hospital Corporation of America v. Commissioner, the Tax Court allowed additional items to be reclassified. The list included certain components of the wiring and electrical distribution systems; conduit, floor, and power boxes; carpeting; vinyl wall and floor coverings; kitchen water piping; doors and partitions; patient corridor handrails; and kitchen hoods and exhaust systems.
The key here is to hire a qualified firm that will prepare a thorough and accurate study, so you’ll be on solid ground in the event of an IRS audit. According to Jim Shreve, principal and managing member of Cost Segregation Services, Inc. in Baton Rouge, Louisiana, “Cost segregation does not increase the chance of being audited.”
A taxpayer who purchases or constructs a qualifying building can benefit from this technique, even if the taxpayer purchased or built several years ago. Qualifying property is classified as residential rental and non-residential real estate. Business owners are great candidates, assuming they own their building, as are individuals who own rental real estate.
How Cost Segregation Works
Normally, a taxpayer who obtains a building will depreciate it over a period of 39 years. Let’s assume that such a building cost $1 million. Under “straight-line” depreciation, the taxpayer would have a depreciation deduction of $25,641 per year. This “deduction” would have the effect of reducing taxable income, and hence, the client’s income tax liability. If the client were in a 35% federal income tax bracket, his tax reduction would be approximately $8,974 ($25,641 x 0.35). If the client were able to shorten the depreciation deduction period, they would be able to reduce their income tax by an even greater amount. Basically, the shorter the depreciation period used, the greater the tax benefit.