Manufacturers who have purchased, renovated or constructed property in the last 15 years can often generate significant tax savings and increase cash flow by using the technique of cost segregation. Cost segregation is the identification and separate depreciation of personal property components and land improvements. Like its predecessor, component depreciation, cost segregation allows a taxpayer to separately depreciate various elements of a building more rapidly than the underlying building itself.
Cost segregation studies enable property owners to defer taxes and benefit from “accelerated cost recovery” through depreciation deductions on assets that are properly identified and classified. Cost segregation is a relatively new practice that evolved from various court decisions and Internal Revenue Service rulings, most notably the Hospital Corporation of America v Commissioner 109 TC 21, in which the taxpayer used the ITC (Investment Tax Credit) rules to reclassify assets from a 39-year to a five-year depreciable life. Cost segregation principles can be applied to new buildings being constructed, renovations of existing buildings, leasehold improvements and purchased real estate going back to 1987. Cost segregation practice requires knowledge of both tax law and the construction process.
A proper cost segregation study will consider the following:
The history of cost segregation has its roots in the manufacturing area since many of the principles used are derived from the former ITC (as noted above) available until its repeal. There is a rich history of case law and Internal Revenue Service rulings supporting treatment of these types of additions as personal property if the asset would have qualified for the credit, or as land improvement property which is depreciated at accelerated rates over shorter useful lives. Consider Scott Paper (74 TC 137), in which the allocations of electrical power usage, traceable to the manufacturing process, were used to treat the additions to the taxpayers’ electrical distribution system as manufacturing equipment and eligible for the ITC as “Tangible Personal Property.” The classification as Tangible Personal Property allows for accelerated depreciation of the assets.
The concepts are straightforward but need to be examined on the facts and circumstances as they relate to the taxpayer and the property involved. Taxpayers who have operated at losses which were limited by some other tax rule may not realize the benefits of cost segregation as it may not change the amount of tax due for a particular period. Proper analysis requires an understanding of the nature of the building owner’s business operations and income tax situation. It is important to evaluate the construction, purchase or, in some cases, changes in ownership that create the perceived need for cost segregation before beginning the process. Once it is determined that there is a potential benefit to be derived, a cost segregation specialist can quantify it and use a team of tax professionals and engineering resources to develop the costs analysis used to support the new classifications and thereby reduced tax liabilities.
Cost segregation results vary from project to project but can produce improved cash flow ranging from $10,000 to well over $100,000 of real value. Manufacturing companies, in particular, can have dramatic results due to the nature of their operations. Manufacturing often requires significant building improvements related to electrical, plumbing and technology which can easily be overlooked and incorporated into building costs, which are depreciated over 39 years. Manufacturing assets, when properly identified, can typically be depreciated over seven years and qualify for “Bonus Depreciation,” or expensing under Section 179. It is the change in the timing of these deductions that produces the value in the form of lower current taxes.
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