Cost-segregation studies: good news for clients.

• Author: Koch, Karen J.

A cost-segregation study is a valuable tax strategy for taxpayers who currently own, are constructing or renovating, or who are acquiring real estate. The reason is simple: tax deductions for depreciation are taken earlier, which translates into a present-value, cashflow benefit.

Depredation

Prior to 1981, taxpayers could depreciate each component of a building separately; for example, the shell might be depreciated over 40 years and the roof over 20. This generally resulted in a composite depreciable life of approximately 20-25 years. The Economic Recovery Tax Act of 1981 eliminated this, requiring all taxpayers to depreciate new or used real estate over 15 years. With such a short composite depreciable Life, taxpayers did not care about losing the ability to componentize.

This schedule was short-lived, however. The Tax Reform Act of 1986 substantially lengthened the depreciation life of real estate from 19 years, to 31.5 years for nonresidential property, and to 27.5 years for residential property. Today, it is 39 years for nonresidential real estate. As a result, real estate owners are now locked into a mandatory, long depreciation life with no ability to componentize.

Although component depreciation was no longer available, the ability to identify personal property embedded in the cost of real estate was still available. Such property could be depreciated over much shorter, modified accelerated cost recovery system (MACRS) lives. Cost-segregation studies make it possible to identify assets installed in a building and to reclassify the allocated costs to Sec. 1245 property, which can be depreciated over shorter lives, ranging from three to 20 years (usually, five, seven or 15). These studies can be performed on just about any property type, including office buildings, hotels, manufacturing facilities, warehouses, restaurants, automobile dealerships, etc.

Segregating Costs

HCA: The general authority for segregating costs between building and personal property stems from Hospital Corp. of America (HCA), 109 TC 21 (1997). In HCA, the Tax Court ruled that if property would have qualified as tangible personal property for investment tax credit purposes, it is properly classified as Sec. 1245 property. Guidance for this conclusion was found in an earlier Tax Court case dealing with the investment credit; see Whiteco Industries, Inc., 65 TC 664, 672-673 (1975).The court in Whiteco hid down six criteria to help identify whether property was...