How often should cost segregation be applied to a building? And are annual updates required or necessary?
Property owners ask this question on a regular basis. A good cost segregation study only needs to be applied once to a building and will calculate the annual depreciation for as long as you own it. However, always ensure that your provider is offering a detailed asset listing so that updates can be applied annually, thereby saving you tens of thousands of dollars more each year! And you may want to do a second study after large improvements. (If you’ve just purchased a property, you should do a cost seg study before you undertake any improvements.)
The Advantages of a Cost Segregation Study
First off, what’s the value of a cost segregation study? The IRS developed the concept of cost segregation so developers could accelerate depreciation of their properties. The IRS’ memorandums define a building as consisting of not only walls, a roof, concrete, and windows, but also land improvements (such as storm sewers, curbs and sidewalks, parking lots, swimming pools, and landscaping) and personal property (such as flooring, interior finishes, decorative lighting, kitchens, interior glass, and electrical wiring for appliances), which should be treated as personal property separate from the structure itself.
Under cost segregation rules, a typical property’s structure is subject to a 39-year recovery period for commercial real estate and 27.5-year recovery period for residential real estate. Land improvements are subject to 15-year recovery period if they qualify for the Qualified Improvement Property (QIP) classification for commercial property only; the improvements are subject to the full depreciation amount if they don’t qualify. Certain other building components qualify as personal property with a five-to-15-year recovery period.
Because land improvements and personal property can now be separately depreciated over the shorter recovery period, the average commercial building owner will realize approximately 25 to 95 percent of their building’s total costs as shorter class-life depreciable assets, depending on the asset type. For canny real estate investors, this translates into major tax savings and increased cash flow.
Because of bonus deprecation, investors no longer have to wait 5, 7, or 15 years for depreciation class lives to become active; they can claim all the reclassified items in year one.
Updating Your Cost Seg Study
With over 20 years of cost segregation experience, we here at Engineered Tax Services know that a cost segregation study is a living, breathing document. It needs to be updated and refreshed periodically.
If you’ve already done a cost segregation study but now plan to go ahead with new improvements, we recommend another study to update and reconcile the disposed assets, demo costs, and new items that have been added.
For example, we recommend a refreshed cost seg study when considering installing a lighting retrofit, refurbishing units, or making general improvements.
Here’s the advantage of commissioning a cost seg report pre-rehab: with receipts/invoices to justify the cost of anything new and details on what was replaced, your client can apply bonus depreciation/partial disposition elections/repair rules. After your client proceeds with the improvements, they can revert back to the original cost seg studies and calculate their partial asset disposition (PAD).
The Power of Partial Asset Disposition
As a deduction, PAD allows property owners to recognize a loss on the disposition of a portion of a building when they make significant improvements; this includes replacing, disposing of, or ripping out existing building components. It’s part of the Tangible Property Regulations (TPR) released in 2013 that revised how businesses decide to expense or capitalize property improvements and purchases. Thanks to TPR, you can write off the retired asset and extract and expense the labor costs for demolition immediately.
Cost segregation studies pay off. Because many improvements may qualify for an immediate write-off as qualified improvement property (15-year QIP), they may not have to be capitalized. As an added benefit, bonus depreciation applies to any property classified to a bucket of 20 years or less, which includes QIP.
Make Your Cost Seg Study Evergreen
If you’ve already completed a cost segregation study, consider having it updated, possibly on an annual basis, before you implement new building improvements. It will pay off in the long run—especially when you take the bonus depreciation and PAD bonanza into consideration.