Cost Segregation For Commercial Buildings
Cost segregation is a powerful tax strategy that can significantly enhance your cash flow by accelerating depreciation deductions on your commercial building. By identifying and reclassifying certain components of your building from 39-year property to five-, seven- or 15-year property, you can front-load your depreciation deductions, reducing your current-year tax liability.
For commercial buildings, the potential for accelerated depreciation is vast. From decorative lighting fixtures and security equipment to specialized wiring for equipment, many components of a commercial building can qualify for shorter depreciation lives. The key is to conduct a thorough cost segregation study that accurately identifies these components.
Types of Property That Can Be Reclassified
In conducting a cost segregation study, ETS aims to reclassify as many components of your commercial building as possible to shorter-lived categories. Here are some examples of property that can be reclassified:
5-Year Property
This category includes items that are not a structural component of the building and can be easily moved. Examples include:
- Decorative lighting fixtures
- Carpeting and other removable flooring
- Window treatments (blinds, drapes, etc.)
- Movable partitions or walls
- Security equipment (cameras, sensors, etc.)
- Certain types of cabinetry (if not permanently affixed)
- Specialized wiring for equipment
- Certain types of plumbing fixtures (if they primarily serve equipment rather than people)
- Certain types of electrical outlets (if they primarily serve equipment)
- Data and communication cabling
Certain types of HVAC equipment (if it primarily serves equipment rather than people)
7-Year Property
This category includes all tangible personal property not included in the five-year or 15-year categories. Examples include:
- Office furniture (desks, chairs, etc.)
- Telephones and communication equipment
- Computers and related equipment
- Printers and copiers
- Audio and video equipment
- Certain types of window treatments (if not included in five-year property)
- Certain types of cabinetry (if not included in five-year property)
15-Year Property
Also known as “land improvements,” this category includes items that are part of the property but not part of the building itself. Examples include:
- Sidewalks
- Parking lots
- Fencing
- Landscaping
- Roads
- Certain types of lighting (if it primarily serves the land rather than the building)
- Stormwater drainage and retaining ponds
- Retaining walls
- Certain types of signage (if it is affixed to the land rather than the building)
Factors Affecting Reclassification
The potential to reclassify components of a commercial building as personal property in a cost segregation study is influenced by several factors. Key considerations include:
Nature of the Component
The IRS maintains precise guidelines delineating what constitutes real and personal property. Generally, elements that are crucial to the building's operation, such as its structural parts, are identified as real property. Items that aren't essential to the building and are easily movable usually fall under the category of personal property.
Use of the Component
How the component is used can also affect its classification. For example, For instance, a piece of equipment used in a business’s operation might be considered personal property, while a similar piece of equipment used for the building’s maintenance might be classified as real property.
Permanence of Installation
The manner in which a component is installed can influence its classification. Objects that are securely attached to the building and can't be removed without causing damage are typically seen as real property. On the other hand, items that can be detached without causing harm to the building are often classified as personal property.
Purpose of the Component
The purpose of the component can also affect its classification. For instance, an integrated cabinet used for general storage may be perceived as a structural aspect of the building (thus classed as real property), while a freestanding cabinet used for business equipment storage might be deemed personal property.
Tax Court Rulings and IRS Guidelines
The decisions made by the tax court and the protocols established by the IRS play a major role in determining the reclassification of a component. For example, the IRS has issued precise guidelines that provide more clarity on the classification of certain items.
Engineering and Construction Practices
Having a thorough understanding of each component's construction and installation process is essential. This requires a deep knowledge of engineering principles and construction practices, which is why professionals specializing in these areas are most qualified to conduct cost segregation studies.
Determining the Value of Assets
Once all qualifying property has been identified, it needs to be assigned an accurate value. This can be difficult without access to highly specialized data sets. At ETS, we use RSMeans data from Gordian, a comprehensive database of various construction costs. We’re able to reference the costs of material, labor and equipment by the unit, assembly or square foot. This allows us to precisely determine the value of all building components and depreciate them appropriately.
Industry-Specific Guidance
Cost segregation studies often interact with other tax strategies, including 1031 exchanges and Opportunity Zone investments.
Interaction With 1031 Exchanges
A 1031 exchange, also known as a like-kind exchange, allows for the deferral of capital gains taxes when a property is sold and the proceeds are invested in a similar property. Cost segregation offers several benefits in this context.
- Previously Conducted Cost Segregation Study: If a cost segregation study was previously performed on the property being sold, the accelerated depreciation claimed reduces the tax basis in the property. This may increase the capital gain from the sale, which will be deferred if the proceeds are reinvested in a like-kind property.
- Cost Segregation Study on the Replacement Property: Performing a fresh cost segregation study on the replacement property accelerates depreciation. This provides significant tax deductions and enhances cash flow.
- Selling the Replacement Property: If the replacement property is sold without another 1031 exchange, there might be a liability for depreciation recapture on the part of the gain related to claimed depreciation deductions.
Interaction with Opportunity Zone Investments
These include deferral of capital gains taxes, a step-up in basis and possible exclusion of future gains if held for at least 10 years.
- Requirement for Property Improvements: When investing in an Opportunity Zone, substantial improvements to the property are typically required. A cost segregation study can identify these improvement costs and accelerate depreciation on them, offering additional tax deductions.
- Immediate Tax Benefits: The accelerated depreciation from the cost segregation study provides immediate tax benefits, while the Opportunity Zone investment allows for deferral and potential exclusion of capital gains.
- Depreciation Recapture: Despite Opportunity Zone investments potentially excluding future capital gains if held for at least 10 years, this doesn't apply to depreciation recapture. Therefore, when the property is sold, tax may still be due on claimed depreciation deductions.
Cost Segregation and Your Financial Statements
A cost segregation study can have a significant impact on your financial statements. Accelerating depreciation deductions reduces your taxable income, thus reducing your overall tax liability and increasing your after-tax net income. This improved cash flow can then be reinvested in your business or distributed to shareholders.
Additionally, reclassifying assets to shorter class lives increases your current depreciation expense, thereby reducing the net income on your income statement. As a non-cash expenditure, this will not affect your cash flow statement. While the overall value of your assets on the balance sheet will remain the same, the composition of those assets will be altered to reflect a decrease in net property and a rise in accumulated depreciation.
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