Cost segregation is a powerful tax strategy that allows commercial property owners to accelerate depreciation deductions, resulting in significant tax savings. While this method is applicable to a wide range of commercial properties, the eligibility and considerations can vary based on the asset class. In other words, some asset classes have better cost segregation results. In this article, we will delve into the types of commercial properties eligible for cost segregation, exploring how unique characteristics impact the process and leveraging recent references to validate our insights.
Understanding Cost Segregation:
Before delving into property types, it’s crucial to grasp the essence of cost segregation. This tax planning strategy involves reclassifying or itemizing certain components of a building to shorter depreciation periods than the standard 27.5 or 39 years depending on the asset class and if it’s a short or long-term rental. Think of cost segregation as looking at the useful life of every Lego piece rather than the building as a whole. By doing so, property owners can front-load their depreciation deductions, providing a boost to cash flow.
Commercial Properties Eligible:
- Residential: From single-family rentals (long and short) to apartment complexes, residential properties can benefit significantly from cost segregation. These properties typically have a mix of items such as flooring, kitchens, bathrooms, fixtures and for complexes amenities such as pools, parking lots and landscaping. Cost segregation enables owners to identify and reclassify these components, optimizing their tax positions and increasing overall cash flow. Often times, owners use the tax savings to pay for renovations to increase rental rates.
- Gas Stations and Car Washes – Probably the BEST asset classes for cost segregation. According to IRS Publication 946, retail properties that derive greater than 50% of their revenue from petroleum-based products OR have greater than 50% of the square-footage devoted to petroleum-based sales, can be fully depreciated over a 15-year period. The Tax Cuts and Jobs Act allows for bonus depreciation on any item placed in a category less than 20-years, meaning if it was placed in service prior to January 1, 2023, it may be eligible for the full value to be bonused into year 1. Car washes similarly can often be fully bonused.
- Office Buildings: Office buildings are prime candidates for cost segregation. These properties often contain a variety of components that can be reclassified for shorter depreciation periods. Examples include interior finishes, lighting, and specialized electrical systems. Cost segregation allows owners of office buildings to more accurately reflect the shorter useful lives of these components and realize immediate tax benefits.
- Warehouses: Characterized by their large and open structures, may seem straightforward, but they often contain components that can be segregated for accelerated depreciation. This can include lighting systems, specialized flooring, cold storage and even certain types of storage infrastructure. By conducting a cost segregation study, owners of warehouses can uncover hidden tax-saving opportunities.
- Manufacturing Facilities: Manufacturing facilities are known for their specialized equipment and infrastructure. Cost segregation is particularly valuable for these properties, as it allows owners to identify and reclassify assets such as production machinery, conveyor systems, and ventilation systems. Accelerating the depreciation of these components can result in substantial tax benefits.
Unique Considerations for Different Property Types:
Each type of commercial property comes with its own set of unique considerations when it comes to cost segregation:
- Profitability: Cost segregation is an amazing tool that creates a legal tax deferral. A tax deferral is only useful if there is income to offset. ALWAYS consult with your accountant and tax team to ensure your property and tax situation can take advantage of this tool.
- Functional Use: The function and use of a property impact the types of assets present. An office building may have extensive interior finishes, while a manufacturing facility may have specialized production equipment. Understanding these functions is key to a thorough cost segregation study.
- Industry Standards: Different industries have varying standards and regulations that impact the components within a property. For example, hotels may have specific requirements for furnishings and amenities. Cost segregation studies need to consider these industry-specific nuances to accurately identify eligible components.
- Building Age: The age of a building can influence the types of materials and systems used in its construction. Older buildings may have undergone renovations or updates that could impact their eligibility for cost segregation.
To validate our insights, we refer to a recent article in the Journal of Accountancy, which highlights the significance of cost segregation for various commercial property types. As we navigate the dynamic landscape of commercial real estate, cost segregation emerges as a strategic approach that goes beyond a one-size-fits-all solution. By tailoring the strategy to the specific components and functions of different property types, owners can unlock hidden tax benefits and foster long-term financial growth.