Industry Insights

Real estate owners have always looked to enhance cash flow and return on investment while lowering income tax liabilities. Accelerating income tax deductions associated with your property is an important tool to reach these objectives. A cost segregation study can be used to reduce tax expense and improve cash flow and investment returns by increasing current depreciation expense.

Real estate cost segregation significantly accelerates depreciation of investments made after 1986 for construction, acquisition or renovation of business buildings and income-producing residential properties. The procedure accelerates income tax deductions by identifying shorter-lived assets qualifying for five-, seven- or 15-year depreciation periods, costs typically embedded in a building’s construction or acquisition costs and depreciated over 27.5 or 39 years. In addition to shortening the depreciable lives, accelerated Modified Accelerated Cost Recovery System depreciation is used on the shorter-lived assets instead of the straight-line method available on 27.5- or 39-year assets.

Cost segregation is performed by tracing derived unit costs from contract documents and other source data. Property is then reclassified into shorter-life asset classes based on applicable tax authorities. This engineering-based approach is the only cost segregation methodology accepted by the IRS.

While the benefit from cost segregation studies will vary based on the type of property owned, properties in many industries may benefit. For example, building uses such as heavy manufacturing, hospitals and surgery centers, light manufacturing, restaurants, grocery stores, automobile dealerships, apartment buildings, retail, office buildings, long-term care facilities, and warehouse and distribution facilities each have their own nuances that must be considered and taken into account during a cost segregation study. Generally speaking, buildings worth more than $1 million or improvements exceeding $500,000 are good candidates.

Under current tax law, you can perform a cost segregation study on a building that was placed in service during a prior year and “catch up” the additional depreciation amount to which you were entitled. Amended tax returns are not required, so it doesn’t matter if the statute of limitations has closed for the year the property was placed in service. This “catch up” is considered a change in accounting method, and the proper forms may be included in your next income tax return to claim this benefit.

For example, if a business owner purchased a hotel seven years ago for $5 million and uses a uniform depreciation method of 39 years, the current-year depreciation before the cost segregation study would be $128,200. After the study, the current-year depreciation would typically increase to around $925,000, reducing the current tax liability by $279,000, assuming a 35 percent federal tax rate.

BKD is one of the country’s largest cost segregation service providers. Our dedicated team of engineers and tax professionals has more than 100 years of combined cost segregation experience, and we perform hundreds of studies every year.

Contact your BKD advisor for assistance in determining whether a cost segregation study could benefit you.