 | What is Cost Segregation Analysis?The purpose of cost segregation is to identify those assets within an investment property that can be reclassified as personal property or land improvements. The motivation is that, while commercial property is depreciable over 39 years, personal property is depreciable over 5 or 7 years and land improvements are depreciable over 15 years. By reclassifying such assets, property owners can greatly increase their depreciation deduction. For example, the table below illustrates the relative annual depreciation for a $100,000 asset in each of these categories.
To put it another way, every asset that is reclassified from 39-year property to 5-year property results in a 780% increase in annual depreciation. A 7-year asset represents a 557% percent increase and a 15-year asset represents a 260% increase in annual depreciation. The table below illustrates the relative tax savings for these assets, assuming an effective 35% tax rate.
Even these numbers don't do the strategy justice as 5- and 7-year property are subject to a 200% declining balance depreciation and 15-year property is subject to a 150% declining balance depreciation. Furthermore, a property owner can catch up on prior years' depreciation in the tax year in which the study was performed. For example, if he has owned the property for seven years prior to having a study performed, he can claim the benefits of all seven years of accelerated depreciation on his current return. The preparation of a quality cost segregation study requires a thorough knowledge of the construction process, including experience in cost estimating, experience in construction accounting and thorough knowledge and understanding of the relevant federal tax depreciation laws. In order to prepare a study, our engineers first obtain and review all available documentation pertaining to the construction of the property. This documentation includes the construction plans, construction cost records and documents pertaining to any capital improvements. In addition to these documents, we obtain and review the owner's closing statement from the purchase of the building, any survey and/or appraisal reports and, the owner's depreciation schedules. In many cases, the original construction records are not available, or cannot be located. In such a case, the engineers must "reverse engineer" the property and identify all of its various components through an intensive on-site inspection. During this inspection, the inspection team identifies and measures all components of the building, including the electrical, plumbing and mechanical systems, as well as all of the other physical attributes of the property. After the review of all available information, and after conducting the site inspection, our team begins the process of segregating each of the property's components and their related costs into appropriate depreciable Modified Accelerated Cost Recovery System (MACRS) property classifications. These classifications, which are based upon the Tax Code, and case precedent, determine which assets can be placed into 5, 7, 15 or 39-year depreciable categories. The determination of the cost allocation for each component uses actual construction records, or, when such records are unavailable, a reasonable and supportable estimation of the labor and materials necessary to construct such component. To this cost allocation, we also include the indirect costs, such as overhead and profit, architectural fees, permits and other related costs in a reasonable and supportable manner. Our findings are then detailed in a report which identifies the total cost of the project and then breaks this number down by component into the four separate categories of 39-year, 15-year, 7-year and 5-year depreciable assets. This report specifies the methodology used in establishing the cost of each of the components and sets forth all additional information required by the IRS to establish the reasonableness and supportability of the conclusions reached therein. This report is presented to then property owner and/or their accountant. | ||||||||||||||||