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Debunking common cost segregation study myths
A look-back study can be performed on older properties. Through a look-back study, a cost segregation study is prepared as of the in-service date and allows you to claim additional depreciation or “catch-up” based on the results of the study, as if the methods and life were retroactive to the year the building was placed in service. No tax returns need to be amended. The adjustment will be picked up in the current tax year on a Form 3115; an automatic change in accounting method must be filed in the year the study is completed to claim the additional depreciation deductions that will be expensed as an IRC Section 481(a) adjustment.
Both residential rental and commercial properties can benefit from cost segregation studies. Commercial properties that undergo renovations or capital improvement projects can benefit from identifying qualified improvement property (QIP), which has depreciation benefits (including bonus and reduction of life for federal tax purposes), and moving the short-life assets to the appropriate asset classes generally assigned a five- or seven-year life. Residential buildings aren’t eligible for QIP but can have a significant amount of short-life property including furniture and fixtures (FF&E).
Although bonus depreciation is dropping to 80% in 2023 (and 60% in 2024, 40% in 2025 and 20% in 2026, assuming no changes in tax law), the study can still break down five- and seven-year FF&E. Even though the full depreciation benefit isn’t in year one, assets that are categorized with a lower life will still be recovered in five-to-seven years vs. 39 years.
This is true, but many tax benefits are just “timing differences.” If you’re looking to accelerate deductions in a foreseeable time, these studies are right for you. If five- and seven-year property (or even 15-year property) is identified in a study, the deductions are far greater than depreciating a 39-year non-residential building or 27.5-year residential building. Given the time value of money in an inflationary environment, why not take advantage of the additional deductions now? If you’re not looking for deductions, then these studies may not be for you.
ASC 805 studies are required for acquisitions of real estate for US GAAP reporters. They identify the value of land and intangible assets, which cost segregation studies do not do, and they don’t break down the building components. The two studies may utilize some of the same information but aren’t interchangeable. A cost segregation study is needed to appropriately break out any shorter life assets from the building to more favorably classify the components for depreciation purposes.
A REIT (real estate investment trust) can take advantage of cost segregation studies to help reduce the taxable income, which helps offset the annual distribution requirements of a REIT entity. A cost segregation study focuses on reclassifying real property and personal property assets into the correct tax lives per federal income tax rules. REITs also benefit from a cost segregation study through the reclassification of the qualified improvement property. REITs have their own set of rules and definitions, and it’s important to understand their nuances while preparing a cost segregation study. Many REITs have benefited from the depreciation benefits of a cost segregation study, all while maintaining the REIT requirements.
Businesses that depreciate any of their own leasehold improvements can still benefit from the study if the assets are on their books. As mentioned above, any assets that are qualified improvement property have a lower life than building 39-year assets and depreciation will be accelerated.
The tax saving benefits from a cost segregation study in the early years outweigh the concern some have about the recapture on the time of sale. The depreciation deductions from a cost segregation study in the first three-to-five years can be significant for an owner. The longer a property is held before resale the greater the benefit.
Hopefully, we’ve debunked some of the misconceptions about cost segregation studies and clarified their benefits. To deliver the most value, it’s crucial to have your study performed by a team with engineering knowledge and tax expertise.
To learn more about the benefits a cost segregation study can deliver to you and your business, please contact our Mazars team today to schedule a consultation.
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