Cost segregation—“cost seg” to a tax accountant—can be a potent strategy for owners of commercial real estate to take advantage of the faster depreciation schedules applicable to qualified components of their properties. The basic contours of today’s approach to cost segregation were established in 1997 by the United States Tax Court in its decision in The Hospital Corporation of America v. Commissioner, 109 T.C. 21 (HCA). The case illustrates how a simple distinction can lead to significant tax savings.
What is depreciation?
In a nutshell, depreciation is used for business or income-generating assets that will be owned for more than a year and therefore cannot simply be expensed. An asset subject to depreciation generates a tax loss for its owner each year over the course of its depreciable life. Depreciation schedules are defined by IRS rules, which provide clear requirements for how particular types of assets are depreciated.
Commercial real estate typically must use a 39- or 27.5-year depreciation schedule. These are long periods when compared with the schedules for other types of assets, which can be as short as 5 years and may qualify for bonus depreciation in the first year of service. The aim of a cost segregation analysis is to identify pieces of a commercial property that might qualify for a shorter schedule, so their depreciation value can be used to offset taxable income more quickly than would be the case if they were characterized as commercial real estate.
The illuminating case of HCA v. Commissioner
The HCA case involved a property that included a hospital building. The taxpayer in the case successfully argued that it should be allowed to treat distinct components of the hospital building’s infrastructure, such as the system that distributed oxygen to outputs in every room, as equipment rather than real estate. By doing so the company would benefit from the much faster depreciation schedule applicable to equipment.
HCA illustrates a key distinction that can help companies begin to think about whether they might benefit from a cost segregation analysis. If a particular asset is structural or essential to the basic function of a building, it must follow the schedule applicable to the building. For example, a building’s electrical wiring is structural.
On the other hand, a building component that is not structural can be treated as a separate type of asset. In HCA the oxygen distribution system was built into the hospital’s walls, but the court still allowed it to be treated as a separate asset type because it was not essential to the building itself.
Is a cost segregation analysis the right approach for your business?
Real estate companies and other property owners are increasingly using cost segregation analysis to identify tax advantages in areas including the purchase of property, renovations, and expansions.
Cost segregation reports can take many forms, depending on the particular needs of the business, the techniques of the preparer, and other factors. The IRS Cost Segregation Audit Techniques Guide provides analysts with the parameters they need to provide their clients with reliable guidance as to whether property is structural or permanent, or whether it can be classified as tangible personal property and therefore eligible for faster depreciation. It’s crucial that a cost segregation analysis include documentation to support the business’s choices in the event the IRS audits its decisions.
At Whittaker & Company we are passionate about cost seg analysis. As part of a comprehensive suite of tax strategies, it can provide owners of commercial real estate with substantial benefits. Is your business getting the most from its real estate assets? Get in touch with us today to start a conversation.