Cost Segregation Studies

By: William J. Killory, CPA (Apr, 2010)

When is a building not a building? When you can perform an engineering study and break the building up into its component parts. The Internal Revenue Code assigns commercial property a depreciable life of 39 years and 27.5 years for residential real estate. This long recovery period delays the tax benefits of owning real estate and creates a mismatch between mortgage payments and the related tax benefits. 

In 1997 The Hospital Corporation of America won a seminal case in Tax Court that allowed them to break down building costs into specific component parts and depreciate them over a five, seven or fifteen year period depending on the classification of component parts of the building. For example, carpeting was given a five year life and the parts of the electrical system traced to the operating room were given a similar life. The structural elements of buildings, such as the roof, elevators or lighting and heating as required by building codes are still assigned the 39 year life. Identifying these elements when you purchase or construct a new building will allow you to write off the remaining balance when you inevitably replace those components long before their tax life has expired. 

The Internal Revenue Service, as you may suspect, is not a fan of breaking the pieces of a building into something with a much shorter depreciable life. In order to sustain an IRS challenge you will need an engineering study provided by an expert in the construction industry that supports the allocation of costs to the shorter lives of the various building components. 

Last year one of our manufacturing clients expanded their plant significantly. The cost segregation study allowed our client to allocate a significant portion of the expansion to equipment cost as there was considerable special plumbing, wiring and construction specifically designed for the manufacturing process. We were able to write off half of the new equipment cost due to bonus depreciation and specifically identify items that qualified for investment tax credits for New York purposes. 

Not everyone is a candidate for cost segregation. The engineers we use will evaluate a project to see if it is cost effective before starting. A simple warehouse does not typically have much specialty construction and is not usually a good prospect. A manufacturing facility or health care provider will typically benefit as there are usually additional costs incurred in these type buildings for electrical, plumbing and air handling.

If you are planning on building or buying a building, no matter what you will use it for it is certainly worth asking about a cost segregation analysis. Real estate is a significant investment and the depreciation rules can be as tricky as they are frustrating. Please give us a call so we can help guide you through the tax aspects of this investment.

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