Benefits of Cost Segregation
A Cost Segregation study (also referred to as a cost segregation analysis or cost seg study) is the process of identifying real property costs, typically in new construction, acquisition or property renovation. The objective is to accelerate depreciation for tax purposes. Cambridge Partners & Associates works with you to help minimize your taxable income through substantiated cost allocation strategies.
Why a Cost Segregation Study is Beneficial
Any recently remodeled, constructed or acquired real estate can benefit from a cost segregation study. The componentization of real estate into the appropriate tax classes allows the property owner to reduce taxable income for the next several years beyond what would be achieved without a study. A cost seg study can have a dramatic near term impact on cash flow by way of reduced income tax expenses.
The current depreciation rules, Modified Accelerated Cost Recovery System (MACRS), require that a newly acquired or constructed building be depreciated over 39 years on a straight-line basis (27.5 years for apartments). Under certain circumstances, MACRS allows for the reallocation of a portion of the property into asset categories having shorter depreciable lives (e.g. 5, 7, and 15 years).
The objective in performing a cost segregation analysis is to shift property (and the associated dollars) from categories that have long tax lives to categories that have shorter tax lives. This allows for greater depreciation during the early years of the asset's life, thereby lowering taxable income and thus lowering taxes. The result of the accelerated depreciation is improved cash flow to the property owner.
How a Cost Segregation Study Works
A cost segregation identifies construction components that are necessary for the operation of the business rather than the operation of the building.
The pure building components must be depreciated over 39 years (27.5 years for residential apartment buildings). HOWEVER, the building's construction components that are required for the operation of the business can be depreciated over a shorter period (usually 5 or 7 years). The shorter asset lives increase depreciation in earlier years, and increased depreciation results in lower taxable income in these early years.
Cost segregation does not eliminate the taxes owed. Cost segregation defers the taxes owed to later years. This results in significant savings today! The after-tax savings can be well in excess of twenty times the cost of the study.
Following is a hypothetical example:
- The assumed state and federal tax rate is 40% and the assumed discount rate (cost of capital) is 12%.
- The building, either new or acquired, cost $5,000,000. A cost segregation study reclassified this cost as follows: 39 year property: $4,000,000; 15 year property: $250,000; and 7 year property: $750,000.
- Based on these assumptions, the present value of the after-tax estimated savings are more than $180,000. You can put these cash savings to work for you now!
Tax Cuts and Jobs Act (TCJA) and 100% Bonus Depreciation
The TCJA has created even greater immediate tax benefits to propery owners electing to have a cost segregation of real estate constructed, renovated or acquired. The act allows businesses to immediately deduct 100% of the cost of eligible property in the year it is placed in service. The amount of allowable bonus depreciation is then phased down over four years: 80% will be allowed for property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026.