Cost Segregation for Investors
In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct methods and proper recovery period for each asset or property owner. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property must be separated into individual components or asset groups having the same recovery periods and placed in service dates in order to properly compute depreciation.
When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to “segregate” or “allocate” costs to individual components of property (e.g. land, land improvements, buildings, equipment, furniture and fixtures to name a few). This type of analysis is generally called a “cost segregation study,” “cost segregation analysis,” or “cost allocation study.”
The most common situation is the allocation or reallocation of building costs to tangible personal property. A building, termed “section 1250 property,” is generally 39 year old property eligible for straight line depreciation. Equipment, furniture and fixtures, termed “section 1245 property,” are tangible personal property.
Tangible personal property has a short recovery period (5 or 7 years) and is also eligible for accelerated depreciation (double declining balance). Thus, a faster depreciation write off (and tax benefit) can be obtained by allocating costs to 1245 property, or by reallocating 1250 property costs to 1245 property.
The underlying incentive for preparing these studies for tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions. You can literally save 10’s of thousands of tax dollars due to the properly reduced Capital Gain at time of sale.
The legitimacy of accelerating these items properly is that it has to be done in the first year it is placed on a tax return. Otherwise the IRS considers this a “Change in Accounting” and has been diligent in not approving your request.