How Can Taxpayers Use Cost Segregation Studies to Find Additional Deductions?

According to the American Society of Cost Segregation Professionals, a cost segregation study is the process of identifying property components that are considered “personal property” or “land improvements” under the federal tax code.

In other words, a cost segregation study, also called a “seg” study, looks for and reclassifies personal property assets to shorten the depreciation time for tax purposes. Doing so reduces the current taxable income for a taxpayer.

Technically speaking, a seg study allows a taxpayer who owns real estate to classify certain assets as Section 1245 property with shorter useful lives for depreciation purposes, instead of the useful life assigned for Section 1250 property. These are associated with Section 1231 property.

Examples of personal property reclassified under a seg study include a building’s non-structural elements, exterior land improvements and indirect constructions costs. With a seg study, the taxpayer finds all construction-related costs which can be depreciated over a shorter life (e.g., 5, 7 and 15 years) than the building itself (39 years for non-residential property).

Personal property assets found in a seg study generally include items which are affixed to a building but do not relate to the overall operation of the building.

Land improvements generally include items external to the building which are affixed to the land. By reducing the useful lives of items like parking lots, driveways, paved areas, site utilities, etc., the taxpayer reduces the income subject to taxation.

Recent changes under tax reform in 2018 have given cost segregation a boost when bonus depreciation increased from 50% to 100% on certain qualifying assets. Real estate investors will receive immediate expensing of certain assets with 5, 7, and 15-year MACRS useful lives.

How to Account for Land Improvements

As stated above, land improvements include enhancements to a plot of land in order to make the land more usable for a business purpose. Specifically, if these improvements have a useful life, they should be depreciated as would occur with any depreciable asset.

However, this may entail some difficulty because there may not exist a way to estimate a useful life. In this situation, you do not depreciate the cost of the improvements. On the contrary, in the event the land improvements prepare the property for its intended purpose, then include these expenses in the cost of the land.

In other words, do not depreciate the land improvements, but capitalize them into the cost of land held on the balance sheet. Some common examples of non-depreciable land improvements include:

Demolishing an existing building

Clearing, leveling and grading the land

Also, as mentioned prior, land does not depreciate because it has no useful life associated with the property. Rather, land has a perpetual life from an accounting perspective.

The only instance where you would “depreciate” land occurs when the land contains natural resources which are being extracted (and the land is being depleted) from alternative investments like oil and gas resources.

Another instance where you may have accounting repercussions for land improvements comes when you add functionality to the land. When you pursue this action and the investments have a useful life, you must record their costs in a separate Land Improvements account.

Some common examples of land improvements include:

Drainage and irrigation systems

Fencing

Landscaping

Parking lots and walkways

In the event you make depreciable land improvements, building owners can use MACRS to depreciate their costs over a shorter period than 39 or 27.5 years. In fact, these qualified land improvements can be depreciated over 15 years at 150% declining balance, with certain personal property depreciated over 5 or 7 years at 200% declining balance.

To identify these eligible land improvements, you must conduct the analysis discussed above in what is known as a cost segregation study.

What is a Short Tax Year?

A short tax year is any tax year with less than 12 full months. A short tax year can occur in the first or last year of a partnership, corporation, or estate’s existence, or when a taxpayer changes from a fiscal year to a calendar year or vice versa.

Because of this shortening, the MACRS depreciation tables from above cannot be used with these short tax years. To compute depreciation in a short tax year, it will depend on the short tax year conventions (mid-month, half-year, or mid-quarter). Also, even in a short tax year, the full amount of Section 179 expense can be taken against taxable income, subject to normal limits.

Instead of using the MACRS depreciation tables, use the following procedure:

Determine the short tax year convention for the property as well as the number of months property is in-service. This will provide the midpoint. Calculate the full year depreciation by multiplying the depreciable basis by the applicable depreciation rate. Multiply the full year depreciation by a fraction comprised of the number of months from Step 1 and the denominator being 12 (months in a year).

Following these steps will prorate the depreciation expense to account for the short tax year.

After a short tax year, you will need to multiply the adjusted basis of the property at the beginning of each tax year by the applicable depreciation rate. If the taxpayer uses the 200% declining balance or 150% declining balance, switch to straight-line in the year the straight-line method yields a higher deduction.

What are the Tangible Property and Disposition Regulations (IRC 263A and 162A)?

Taxpayers who own depreciable assets or who buy, sell, improve or dispose of assets must comply with the tangible property regulations for tax years beginning on or after January 1, 2014. The Tangible Property and Disposition Regulations provide guidance on the application of § 263(a) and § 162(a) to amounts paid to acquire, produce, or improve tangible property.

These regulations provide specific guidance around the treatment of improvements made to property for depreciation purposes.

§ 263A denies a deduction for any amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. It also denies any amount expended to restore property or allowances made for such restoration.

Previously, guidance under § 263(a) provided capital expenditures included amounts paid to add to the value or substantially prolong the useful life of property owned by the taxpayer, or adapt the property to a new or different use.

IRC 263A generally requires direct and allocable indirect costs must be capitalized to property produced by the taxpayer and property acquired for resale. Section 162 allows a current deduction for amounts paid of incurred for incidental repairs and maintenance and does not require capitalization of these amounts.

The regulations under § 1.263(a)-3(h) permit qualifying small taxpayers to forego application of the improvement rules on eligible building property. This safe harbor for small taxpayers has the following requirements for qualifying:

Be a qualifying small taxpayer (average annual gross receipts for three preceding tax years less than or equal to $10m )

) Own (or lease) eligible building property;

Not exceed the applicable cost of improvement threshold; and

Properly elect the safe harbor.

Conclusion

Under the tax code, Congress established and the IRS oversaw a more rewarding accelerated depreciation system to induce companies to invest and expand their operations, thereby growing the economy. Or so the argument goes.

While there is much debate about the effectiveness of the MACRS system, many corporate managers have not shown bias toward the tax benefit and taken advantage of it nevertheless.

Despite the unclear evidence of whether accelerated depreciation truly increases investment in the long-run, it has provided companies with ample opportunity to use time value of money to their advantage. This is because corporations can use MACRS depreciation, bonus depreciation, and Section 179 deductions to accelerate their depreciation expense from a tax perspective.

Doing so lowers their tax burden today when a dollar is worth more while increasing it in the future when it is worth less. In other words, the total taxes paid are the same but when they are paid differs.

So long as you provide tax incentives for certain actions, businesses will plan to take advantage of any available opportunity to improve the profitability of their operations.

Readers: Now that you know more about MACRS depreciation and the related concepts, what are your thoughts? Do you use the system in your trade or business to lower your taxable income? What do you like or dislike about the system? What can be improved? Also, if you found this post to be of value, I ask that you please consider sharing it on social media because I need your help getting this out to a wider audience.

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A Disclaimer: The information in this post and on this site is intended to be general and is not intended to be construed or used as tax or legal advice. Check with your tax professional before making business decisions which can affect your taxes.