When cost segregation costs extra.

• Author: Wood, B. Sue

EXECUTIVE SUMMARY

* Cost segregation is a tax planning technique that accelerates depreciation deductions for real property by reclassifying elements of a building as tangible personal property eligible for MACRS depreciation. The technique may be advantageous when the discounted value of the tax savings exceeds the costs of its implementation.

* One potential pitfall of cost segregation is its impact on a later exchange of the building for like-kind property. Generally, a taxpayer recognizes no gain or loss in a like-kind exchange of real estate. The creation of multiple asset classes makes it likely that gain will be recognized in an exchange that otherwise would be nontaxable, which may largely offset the initial benefits of cost segregation.

* When a client is contemplating cost segregation, the tax adviser should discuss with the client the potential for an exchange of the property and incorporate an exchange in the analysis when appropriate. Failure to do so can lead to an unexpected and unfortunate tax and cashflow result. What a taxpayer gains in accelerated depreciation may be more than lost in a like-kind exchange.

**********

[ILLUSTRATION OMITTED]

Cost segregation is a popular tax planning technique for owners of depreciable real property. While it is a legitimate and sometimes beneficial technique, some taxpayers have adopted it without considering the potential adverse consequences that can occur upon disposition of the property. In particular, taxpayers and their advisers should be aware that cost segregation can result in later recognition of gain in a like-kind exchange of the property when gain otherwise would not have been recognized.

Cost segregation, also called componentization, reduces tax by accelerating depreciation on components of a building. Depreciation is accelerated by reclassifying components as 5-, 7-, or 15-year modified accelerated cost recovery system (MACRS) property rather than 39-year straight-line real property. This technique was revitalized in the case Hospital Corporation of America, (1) in which the court allowed the taxpayer to categorize assets in a hospital into many classes depending on their separate lives based on whether the assets could be removed from the building and a number of other factors (discussed below). Assets such as lighting systems, movable walls, and ceiling grids were determined to be separable from the real property or supporting a separable activity and thus eligible for accelerated depreciation.

Examples of 15-year property include outdoor lighting, signage, and landscaping. Typical 7-year assets include floor and window coverings, decorative millwork, and electrical fixtures. Some assets identified in a componentization study may qualify for Sec. 179 expensing and/ or bonus depreciation, which could further accelerate depreciation. These assets are not generally those that would be treated as personal property in a like-kind exchange as would appliances and other freestanding equipment. (2)

Like-kind exchanges under Sec. 1031 allow a taxpayer to defer recognition of realized gains when exchanging property for like-kind property. Because of the broad definition of "like-kind" real estate, this technique is especially valuable to owners of commercial and residential rental real estate. In fact, Sec. 1031 has spawned an entire industry of specialists who broker transactions and serve as qualified intermediaries in exchanges.

Similarly, componentization has caused the creation of firms that value buildings by asset class as well as advise on proper lives and potential future taxation. They evaluate a building and segregate its components into parts or segments that normally are thought of as integral but...