Cost Segregation or ‘the Decomposing of Your Building’
Definition, economic benefits and more disclosed.
June 4, 2009
In a recent discussion with Erick Cutler, CPA, and partner in the Dallas, Texas-based firm of Goldin, Peiser and Peiser, LLP (GPP), I was able to get a better understanding of what cost segregation is all about.
What Is Cost Segregation?
Cutler explained that cost segregation entails the “decomposing” of a building right down to its wiring for the purpose of maximizing deprecation expense for federal income tax purposes. Basically, it shifts individual items that may have been lumped into the total cost of a building into categories that have a shorter life for tax purposes. Wiring in a medical building that had been dedicated to medical equipment would qualify for a shorter life (five years, seven years or 15 years) than the general wiring in the building, which would be considered part of the building and depreciated over 39 years. Other examples that he used were: general plumbing in the building would be considered part of the building, but plumbing used for a dental chair would qualify for a shorter life; electrical wiring for tech support and data lines; an interior window that allows one to see into the next office or entry way (exterior windows would be part of the building with the longer life); extra concrete used to support the storage area in a manufacturing facility; special shielding used in the walls of a doctor’s office that does open imaging, special drainage layers used on the greens of a golf course, and the wiring that goes to machinery in a factory.
‘Decomposition of Buildings’
How do you “decompose” the building to find the costs and indentify the specific items that are eligible for a shorter life? Cutler explained that it is a joint effort of an engineering firm and an accounting firm to locate the items and then determine the proper life for depreciation purposes. The procedure includes obtaining the basic information-cost, placed in service and any specific usage or specific tenant. It usually entails a site visit by an engineering firm so that they can note any items that would require special plumbing or wiring. They may find special finish-out or details that would be lumped into the building costs.
Example: An onsite visit to a manufacturing facility, an engineer noticed that the finished products, which weighed several thousand pounds each, were all stored in a separate section of the building. Based on his engineering experience and background, he knew that the ordinary foundation would not support that weight. After some checking, he found that it indeed did have six extra feet of concrete poured in that portion of the floor beneath the regular foundation. That extra concrete was originally included in the building construction costs and was being depreciated over 39 years. By segregating the costs, the owners of the building were able to use a shorter life for the extra concrete.
Cutler pointed out that in addition to the site visit in the above example, a detailed study of both the general and mechanical blueprints of the building was made by both the engineering and the accounting firm working together. Further information that is usually required from the taxpayer would be tax deprecation schedules, any appraisals and any capitalized costs for the project.
Qualifications for Cost Segregation
In GPP’s brochure, they point out that while any commercial property may qualify for substantial tax deferral and cash-flow benefit, there are certain property types that have a higher probability of significant cash flow benefits. They list office buildings, industrial facilities, manufacturing facilities, airport hangars, restaurants, country clubs, hotels and golf courses to name a few.
But how does the IRS view the catch up adjustment for depreciation? Cutler explained that IRC Sec. 481(a) allows a catch up adjustment for prior year’s missed depreciation and is deductible in the current (emphasis added) year (Rev Proc 2002.19). He went on to explain that a building bought in 1990, using a 39-year depreciation life could, after identifying items with a shorter life, do a look back to 1990, and any additional depreciation identified could be deducted in the current year. He also noted that the IRS has guidelines for the life of assets segregated as a result of the cost segregation. In addition to the schedules, findings and substantiate of the additional depreciation, one must file Form 3115 to change the depreciation method which usually gets an automatic approval from the IRS.
With the current economy as it is and companies not showing any taxable income, what is the benefit of accelerating the depreciation expense? With the new net operating loss (NOL) rules, a company may be able to use the accelerated depreciation to recover taxes they paid in the past, or, if they are anticipating paying taxes in the near term, this may be a way of reducing them.
So what are the triggering events that one should consider cost segregation? Again, per GPP’s brochure:
So how does one determine the economic benefit of doing cost segregation? After some initial inquiries most firms that do cost segregation can give a taxpayer a fairly good estimate of what additional depreciation they can expect as a result of the engagement. They can then determine the cost of the engagement to the potential tax savings and see if works for them.
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Allen M. Liebnick, CPA, is president of Overpaid Payables Recovery, Inc. A former associate professor, Liebnick has been providing accounts payable, sales tax and telecommunications post audit recovery services for over 15 years. He serves clients in the U.S., Canada and Mexico. He is a member of the New York State Society of CPAs as well as Texas Society of Certified Public Accountants. Liebnick thanks Erick Cutler for participating in this article. Corporate Finance Insider readers who have questions for Cutler can contact him directly to ask any questions you might have, feel free to contact him at ECutler@GPPcpa.com.Tell him Allen sent you.