Cost segregation studies.

• Author: Welker, Curt J.

The benefit of a cost segregation study (CSS) is well known to many tax advisers (see Langely and Heard, Tax Clinic, "Cost Segregation: A Genuine Tax Savings Strategy, TTA, April 2002, p. 215). Absent a CSS, newly constructed or purchased property often yields only modest depreciation deductions. By breaking out shorter modified accelerated cost recovery system (MACKS) depreciation lives for personal property and 15-year land improvements from 31 1/2- or 39-year real-property depreciation, a CSS could greatly accelerate a building's tax depreciation.

The new accounting-method-change rules set forth in Rev. Procs. 2002-9 and 2002-19 provide further reason for a CSS: they allow taxpayers who did not previously use a CSS to conduct one now for a building placed in service in an earlier year. Using a Sec. 481(a) adjustment, a taxpayer can take in one year all previously forgone depreciation that would have been available in prior years for a shorter-life property. The procedures allow taxpayers to request an accounting-method change up until a return's extended due date. This allows taxpayers to plan and secure additional deductions retroactively after the close of the tax year.

Considerations

Even though a CSS is often an effective tax-planning tool, taxpayers should first consider whether their circumstances make a CSS advisable. First, for less expensive building projects, a cost/benefit analysis should be calculated, comparing a CSS's cost against the net present value (NPV) of the projected tax savings. Typically, a proposal to perform a CSS will include an estimated NVP as an attachment (see Exhibit 1). However, this calculation normally assumes the project will be held for a real property's full life (i.e., 311/2 or 39 years). If a taxpayer is planning a taxable sale of the property within a short time, justification becomes difficult, because the benefits are in timing differences that will ultimately reverse (see Exhibit 2).

Second, by carving out personal property from the building, a portion of the gain on any future sale could be taxed at ordinary rates as Sec. 1245 gain on personal property depreciation recapture. Absent a recharacterization of the property under a CSS, the real-property Sec. 1250 depreciation recapture rate would be only 25% for non-corporate taxpayers.

Many practitioners attempt to mitigate this result by arguing that the personal property's fair market value (FMV) at the sale date is equal to or less than the depreciated tax basis. This argument might be difficult to sustain on an IRS examination if the personal property is fully depreciated or the new buyer is conducting a CSS that quantifies a significant amount of the personal property's FMV at the sale date. The rate differential on a reversal of the depreciation could negate the savings from the timing difference on the MACRS depreciation.

Third, the presence of personal property may make entering into a tax-deferred Sec. 1031 like-kind exchange more difficult. If a taxpayer were to trade into real property with little or no personal property (e.g., unimproved land), the...