Catch-up opportunities for depreciation.

• Author: Simon, Dara M.

Selecting the proper class life for assets placed in service may allow a business to increase its cashflow by accelerating depreciation and thus deferring federal and state income taxes. Often little thought is given to assigning the proper class life to an asset when it is placed in service. In many cases, the ability to classify an asset as one with a shorter life eligible for accelerated depreciation is not recognized until years after the asset has been placed in service. All is not lost, however, because it is possible to retroactively "catch up" on depreciation not previously claimed.

This can be accomplished by switching to the proper class life and taking advantage of revenue procedures that allow taxpayers to deduct in one year the cumulative difference between the depreciation taken on an asset previously placed in service and the amount of depreciation that would have been taken using the proper method. This catch-up frequently results from a cost segregation study performed in connection with a property that was acquired a few years earlier. As a result of these procedures, it is possible to significantly increase cashflow from the tax savings generated by the deductions made available with this approach.

Cost Segregation

Cost segregation is the process of determining the proper classification of an investment in a facility between structural and nonstructural property. The various cost components are identified, separated, and reclassified into tangible personal property and other items eligible for shorter depreciable tax lives than the lives applicable to real property. By reallocating a significant portion of the costs from longer recovery periods (27.5 or 39 years) to shorter recovery periods (5, 7, or 15 years), the depreciation expense is accelerated, providing increased cashflow and tax savings in the early years of the asset's life.

Although in many cases the total depreciation is exactly the same, the benefit of cost segregation comes from the time value of money. Put another way, a tax deduction today is worth significantly more than a tax deduction in the future.

Ideally, a cost segregation study should be performed for the year the real estate is first placed into service. However, the IRS allows taxpayers to deduct catch-up depreciation on the difference between the depreciation taken to date and the depreciation that could have been taken using cost segregation techniques. Cost segregation may apply retroactively...