Cost Segregation Studies: Benefits to Building Owners and Contractors Alike

3/1/2016 - By Zachary Farrington

-This excerpt is from our Spring 2016 Dimensions Newsletter-

In recent years, a growing number of commercial property owners have been able to improve after-tax cash flow by accelerating their depreciation deductions for certain building components. The key to achieving these benefits is the completion of a cost segregation study, which identifies certain building systems and components that qualify for accelerated deductions.

The use of cost segregation studies began increasing in the late 1990s, following several prominent tax court cases and related IRS rulings. Interest intensified further after 2013, when the IRS issued new tangible property regulations governing the capitalization and depreciation of certain capital expenditures.

Contractors who own their office, warehouse or shop facilities have an obvious interest in having a cost segregation study performed. It could help them defer taxes, reduce their current tax burden, free up capital, and ultimately improve their return on investment.

But even contractors who do not own commercial property directly can benefit by understanding what cost segregation studies do and recognizing how they can be used to benefit their customers.

How Building Owners Can Benefit
Commercial property typically is depreciated over 39 years, while residential rental property, including multifamily housing projects, is generally depreciated over 27.5 years. But certain building components and systems — electrical installations, plumbing, mechanical systems and finish components, for example — qualify for shorter depreciation recovery periods of five, seven or 15 years.

Cost segregation studies identify construction-related costs that can be depreciated over these shorter time spans. By accelerating depreciation schedules, the building owner can reduce current tax obligations and increase cash flow.

While cost segregation studies can be particularly helpful in improving the cash flow on new construction, they can also provide tax and cash flow benefits for existing structures. In fact, virtually every taxpayer who owns, constructs, renovates or acquires a commercial real estate structure could potentially benefit from a cost segregation study.

For example, under the tangible property regulations issued in 2013, certain repair and maintenance expenditures can be expensed immediately while other expenditures must be capitalized and depreciated over a period of years. Cost segregation studies help define the specific costs related to these various building components so that building owners can apply the proper tax treatment.

Added Opportunities
Beyond offering potential tax benefits to building owners, cost segregation studies can also give contractors a way to provide added value to their customers, thus strengthening and deepening customer relationships.

In its Cost Segregation Audit Techniques Guide, the IRS says, “Preparation of cost segregation studies requires knowledge of both the construction process and the tax law involving property classifications for depreciation purposes.” As a practical matter, this generally means the study is a joint effort involving both construction engineers and CPAs, but building contractors also have an important role to play. Many contractors have qualified construction engineers and cost estimators on staff who can support the effort.

Even if they don’t play a direct role, however, contractors can help streamline the process by coordinating with the study team and providing the detailed construction cost data that’s needed, organized in a way that helps the team complete the study accurately and quickly. This means an astute building contractor will want to understand and recognize the various asset class life designations for the relevant building systems and components.

Ultimately, by helping building owners accelerate their tax deductions and improve cash flow, a cost segregation study can make funding of new construction or improvements more feasible — a situation that benefits building owner and contractor alike.