James Lamont of Lamont Financial Services explains how the IRS views cost segregation as the most accepted method of asset classification for calculating and deducting property depreciation.
Cost segregation is the practice of dividing commercial real estate into two categories: real property and personal property. The purpose is to take advantage of IRS rules that allow personal property to be depreciated earlier than real property. Depreciation is a significant part of a property’s value that can significantly reduce the owner’s tax liability and increase cash flow.
Some commercial property owners have expressed apprehension about pursuing cost segregation as a tax reduction strategy because they think it will draw IRS scrutiny. A common misconception is that cost segregation involves taking advantage of a loophole and that the IRS considers it to be an aggressive tactic.
This couldn’t further from the truth. There is really nothing aggressive about dividing property into real and personal property. In fact, the IRS has published very clear guidelines for how to do it.
To understand the IRS’s position on cost segregation, it’s helpful to know its history. Prior to 1981, the IRS allowed a similar kind of property depreciation benefit called component depreciation to classify assets for the purpose of depreciation deductions. In 1981, Congress enacted legislation that expressly prohibited component depreciation, shifting the depreciation process to a system it called Investment Tax Credit (ITC).
Instead of deductions, the IRS issued tax credits for the depreciation values. The benefit from accelerating depreciation deductions was not as great at it is today because real property was depreciated over shorter time periods and (15 to 19 years) making the difference between personal property depreciation schedules (5, 7, or 15 years) less significant and less beneficial.
In 1987, the IRS changed the depreciation period to 27.5 years for residential real property and 31.5 years for commercial real property; and the recovery period for commercial property was extended to 39 years for buildings placed in service after March 1993. With the longer recovery periods, the benefit of reclassifying personal property with depreciation schedules of 5, 7, or 15 years became much more substantial.
As the IRS shifted back to depreciation deductions from tax credits as a depreciation benefit, the benefits of accelerated depreciation became more attractive and property owners returned to the component depreciation/cost segregation process of claiming deductions. The IRS initially challenged most of the basic concepts utilized in cost segregation, and in turn many property owners challenged the IRS. The issue was settled in favor of property owners in a 1997 court case (HCA vs. Commissioner, for those who want to know), and cost segregation essentially became the law of the land.
This status was fully validated in 2004, when the IRS published a Cost Segregation Audit Techniques Guide to direct its auditors on how to handle cost segregation practices in audit cases. While intended for auditors, the guide provides property owners with clear guidelines for cost segregation that the IRS will accept.
Here is an excerpt from the Cost Segregation Audit Techniques Guide:
In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property must be separated into individual components or asset groups having the same recovery periods and placed-in-service dates in order to properly compute depreciation.
Cost segregation is not really elective (asset classification is not required by law, but cost segregation is required when reclassifying assets) and it not seen as aggressive by the IRS. It is battle-tested in court and is now expected and accepted when done properly. In fact, cost segregation is described by the IRS as the “required” method for accurately measuring and classifying costs for depreciation purposes.
When reclassifying real property, a cost segregation study is the approved method of identifying assets classifications and assigning values. A cost segregation study is engineering document typically performed under the guidance of a cost segregation consultant, accountant advisor or engineer specializing in this service.
Lamont Financial Services offers cost segregation services in partnership with Core Solutions Group. Core is a one of the nation’s most trusted authorities on cost recovery for commercial real estate owners and investors.