Taxpayers using real estate in their business often can generate significant tax savings and increase cash flow by using the technique of cost segregation. Cost segregation is the identification and separate depreciation of personal property components and land improvements. Like its predecessor, component depreciation, cost segregation allows a taxpayer to separately depreciate various elements of a building more rapidly than the underlying building itself.
Real and personal property
Under MACRS, a building must be depreciated over 27.5 years (residential rental property) or 39 years (nonresidential real property), using the straight-line method. Cost segregation allows depreciation and recovery of the cost of personal property elements of the building over five to seven years, using an accelerated depreciation method (200-percent declining balance). Components that are not classified as personal property must be included in the building’s basis and depreciated over the appropriate period as real property.
Building elements are eligible for cost segregation if they are considered personal property under Code Sec. 1245 and under the former investment tax credit rules of Code Sec. 38. Classification as personal property under state law can also avoid state and local real property taxes.
Cost segregation study
To use cost segregation, the taxpayer must obtain a cost segregation study, which may be conducted by a cost segregation specialist. The specialist will conduct a feasibility study to determine whether a cost segregation study can provide tax savings. The building must be inspected, and the study must identify the components that may qualify as depreciable personal property. The actual installed cost of the component must be obtained.
The items of personal property must be identified in the study. The study should also provide the legal authority (regulations, cases, rulings, etc.) for treating an item as personal property or a land improvement, and should explain the methodology for determining the property’s depreciable basis.
Ideally, the study should be conducted before the building is placed in service (e.g. when the building is under construction or at the time of purchase), although the study can be conducted after a building is placed in service. The building does not have to be new. If the building is being purchased, the sales contract can allocate the sales price between real and personal property.
The IRS has provided unofficial guidance to its examiners for reviewing cost segregation studies – Audit Technique Guide for Cost Segregation, dated March 2008. The guide explains why studies are prepared, how studies are prepared, and what to look for in reviewing a study. The guide is available on the IRS website. The IRS also described cost segregation methodology in a private letter ruling, PLR 7941002. Both guidance documents remain in current use by both taxpayers and IRS agents in assessing the correctness of any particular cost segregation study.