Fun Asia Show Recording-November 21, 2013

Cost Segregation – How It Can Save Tax

Tax Issue

Taxpayers who acquire real property for use in their business are faced with depreciating real property over 27.5 or 39 years. Certain costs incurred in constructing or acquiring real property often qualify for accelerated depreciation. The ability to shorten the depreciation period can substantially decrease the tax liability of a business and increase its cash flow. It is important to have documentation supporting the reclassification of building components to tangible personal property depreciable over shorter periods.

Applicable Tax Law

  • Buildings (section 1250 property) are generally eligible for straight-line depreciation over 39 years (27.5 for residential rental property).
  • Tangible personal property (section 1245 property) has shorter depreciable lives (e.g. five, seven or 15 years) and is eligible for accelerated depreciation methods.
  • The primary issue in cost segregation studies is the proper classification of assets as either section 1245 property or section 1250 property.
  • Cost segregation studies identify specific project components that qualify as tangible personal property.
  • Cost segregation studies may also allocate a portion of the building components as tangible personal property. For example, a study may conclude that 15% of a building’s electrical system directly supports tangible personal property such as specialized kitchen equipment. Based on that conclusion, the study will then treat 15% of the electrical system as tangible personal property.
  • Classifying building components and identifying project components as tangible personal property provides taxpayers the benefit of decreasing taxable income by accelerating depreciation deductions.
  • Cost segregation studies can be used on previously acquired or remodeled structures to justify depreciation reclassification. When this situation arises, the taxpayer is allowed to make a section 481 adjustment under the automatic change rules and change its depreciation method. This procedure allows a taxpayer to claim any previously unclaimed depreciation, calculated as a result of reclassifying property to a shorter life, in the year of change.

Tax Planning Strategies

Taxpayers who have purchased, constructed, or renovated commercial and rental real estate may benefit from allocating as much of the coast as possible to personal property to more quickly deduct the depreciation. A cost segregation study is usually required to determine the portion of the project allocable to personal property and to withstand IRS review. The IRS does not require any specific method for cost segregation studies, but the IRS does list some of the more common methods and notes the method depends on the facts and circumstances of each project.


Example: In 2009, A1 Knitting, Inc., a calendar year taxpayer engaged in the trade or business of manufacturing knitted goods, purchased and placed in service a building and its components at a total cost of $1,500,000 for use in its manufacturing operations. $500,000 of the purchase price is allocated to land. A1 Knitting, Inc. classified the $1,000,000 ($1,500,000 – $500,000) as nonresidential real property. A1 Knitting, Inc. elected not to deduct the additional first year depreciation provided by section 168(k) on its 2009 tax return. On its 2009, 2010, and 2011 tax returns, A1 Knitting, Inc. depreciated the $1,000,000 under the general depreciation system using the straight-line method of depreciation, a 39-year recovery period, and the mid-month convention. In 2012, A1 Knitting, Inc. completes a cost segregation study on the building and its components and identifies items that cost a total of $150,000 as section 1245 property. As a result, the $150,000 should have been classified in 2009 as 5-year property and depreciated on A1 Knitting, Inc.’s 2009, 2010, and 2011 tax returns under the general depreciation system, using the 200% declining balance method of depreciation, a 5-year recovery period, and the half-year convention. A1 Knitting, Inc.’s change to this depreciation method, recovery period, and convention is a change in financial record keeping method and this method change results in a section 481 adjustment in 2012.

As a result of the cost segregation study, A1 Knitting, Inc. is able to make a section 481 adjustment under the automatic change rules and depreciate $150,000 of the $1,000,000 building purchase over five years instead of 39 years.  A1 Knitting, Inc. can claim the previously unclaimed depreciation on the 5-year property in 2012, the year of change. The remaining $850,000 ($1,000,000 – $150,000) allocated to the building continues to be depreciated over 39 years.

Possible Risks

  • Distinguishing between tangible personal property and a building made up of its structural components is an area of controversy. There are many court cases, legislative acts, and IRS rulings which have produced complex and often conflicting guidance. Each situation is determined by its unique facts and circumstances.
  • A cost segregation study typically pays for itself. However, the upfront fees for the cost segregation study vary greatly depending on the size of the building, the type of building project, and the expertise of the individual performing the study.
  • A cost segregation study performed in house by the taxpayer often faces increased scrutiny under IRS audit. The IRS, in written guidance to its auditors, notes that a specific cost segregation method is not required; however, there are certain approaches that produce more accurate and reliable allocations. Even with the use of one of the more reliable methods, issues may still arise with respect to the proper classification of tangible personal property.

Court Cases

Court Case: The taxpayer used gypsum board partitions in its rental operations that could be readily and economically moved and reused. The removal process did not damage the building structure. The taxpayer had in fact removed and reused the partitions on many occasions. The court ruled that the partitions were tangible personal property. The court noted that regulations define structural components to include walls and partitions as they relate to, and are often essential to, the operation and maintenance of the building and are permanently installed. However, in this case, the court determined the removable partitions had only incidental relationship to the operation or maintenance of the building.

In the same case, the court held that toilet partitions were a structural component of the building. The toilet partitions were easily movable without substantial damage to the structure. The partitions had been removed temporarily for repair purposes. The court noted that movability is not the sole test. The court focused on the fact the toilet partitions were not likely to be moved and related to the operation of the building. (Metro National Corporation, T.C. Memo 1987-38)