Whether you’re an accountant, an enrolled agent (EA), certified tax preparer, or even a tax attorney, your clients typically look to you for one thing above all others: saving them money. It’s true. It doesn’t matter what the client’s line of work is, what their tax burden may or may not be, or what sort of structure their business and/or personal holdings might take. No matter the situation, practically every client you work with is interested in saving as much on their taxes as possible.
There are a lot of ways to make this happen. Opportunities for deductions abound, and it’s your job as an accounting or tax professional to bring as many of those deductions into play as possible for your client. At the same time, the recent 2018 tax reform changes have resulted in a significant increase in the standard deduction. Now, the standard deduction comes to $12,000 for single individuals, $18,000 for heads of household, and a full $24,000 for married couples filing jointly.
The increase in the standard deduction combined with changes to the maximum allowed amount of state and local tax deductions will likely result in fewer individuals itemizing their deductions. Still, though, there are major advantages in certain cases to itemized deductions. For some clients in particular, specific tax techniques can result in massive tax savings from year to year.
When it comes to saving your clients money, one of the most effective tax deduction techniques out there is cost segregation.
What is cost segregation? How does it work? When is it appropriate to use? Are there audit risks associated with it? Is it worth the work involved in performing a cost segregation study?
These are complex questions. If you want to learn everything there is to know about cost segregation, we highly recommend allocating some of your annual CPE credits to taking an online tax webinar that’s focused specifically on this topic. There’s a ton of ground to cover, and it’s a great way to put your CPE credits to good use. Believe us: one of your clients is eligible for cost segregation and you manage to put this technique to work for them, they’ll be thanking you. Cost segregation has the potential to save your clients massive amounts of money in taxes over the long haul.
That said, we’ve put together this blog post to touch on some of the key aspects of cost segregation. In this post, we’ll cover:
- What cost segregation is
- A brief history of tax law leading up to cost segregation
- How cost segregation can help your clients
- How assets are segregated
- Conducting a cost segregation study
- When to use cost segregation for your clients
Ready to learn more about cost segregation? Let’s get started.
When you put it in plain and simple terms, cost segregation doesn’t sound technical at all. In fact, it sounds like a statement of the obvious. Simply put, cost segregation is the process of identifying various assets and the costs of those assets individually, and then properly classifying them for the purposes of federal tax deductions.
So, how is cost segregation different from the work that typically goes into totaling up a client’s potential deductions? Well, cost segregation as a term isn’t used to simply refer to the process of tallying up a client’s expenses and placing them into the appropriate categories for deductions. Instead, we use the term cost segregation when we’re talking about a very specific type of asset allocation.
Specifically, cost segregation is utilized for the reallocation or reclassification of real property assets. By using this technique, you may be able to dramatically increase the total amount of tax deductions for which your clients are eligible in the near future.
Before we delve deeper into the advantages of cost segregation — including both how it actually works and what it takes to perform a so-called cost segregation study — let’s take a moment to briefly examine the history of tax law leading up to today.
A brief history of relevant tax law
Years ago, the tax law was written in such a way that a taxpayer would actually calculate the value of and subsequently depreciate all sorts of individual items that their business owned. We’re not talking individual pieces of equipment, either: it wasn’t uncommon for a business to separate a building into doors, walls, floors, and so on, and then deduct them individually. Once these assets had been identified, they would generally be depreciated using the shortest possible period for cost-recovery. This was termed as “component depreciation” by various tax professionals.
This whole process was disrupted by the introduction of the Accelerated Cost Recovery System (ACRS) and the Modified Accelerated Cost Recovery System (MACRS). These new systems essentially eliminated the ability of taxpayers to engage in component depreciation. However, these systems did not expressly prohibit all forms of cost segregation.
In 1997, a landmark court case took place involving the Hospital Corporation of America (HCA) and the commissioner of internal revenue. The Hospital Corporation of America sought to utilize cost segregation to treat individual aspects of newly purchased real estate assets as separate assets, thus allowing them to deduct those assets on a shorter depreciation schedule. The Tax Court ruled in their favor.
While we won’t go into all of the details of this court case, it’s useful to note some of the deductions and depreciation terms that the Hospital Corporation of America was allowed. The standard depreciable life for a commercial building is 39 years, which means that depreciation must be stretched out over an incredibly long period of time. Thanks to cost segregation, however, the Hospital Corporation of America was able to separate out the following aspects of their commercial real estate assets and depreciate them on a 5-year schedule:
- Electrical distribution systems
- Laboratory wiring
- Power boxes and conduits
- Vinyl flooring
- Special plumbing
- Kitchen exhaust systems
How can cost segregation help your clients?
At first glance, you might be asking yourself: why would anyone go to all that trouble? Why not simply depreciate the entire building rather than breaking it down into its individual components? Isn’t that incredibly complicated? Wouldn’t it result in all sorts of extra costs associated with assessing the property, logging each individual asset, and depreciating them separately?
Indeed, cost segregation comes with certain costs (and risks, as we’ll see below). In fact, as we’ll discuss in the next section, utilizing cost segregation as part of your client’s tax return will involve conducting a so-called cost segregation study, which includes an engineering component. Incidentally, the level of complexity involved when it comes to utilizing this technique is one of the reasons that we recommend setting aside some of your annual CPE credits to take a webinar dedicated to this topic.
That said, let’s consider why cost segregation can be worth it.
Imagine that a client purchases a building for $1,000,000. This building is depreciable over the course of 39 years. Assuming the client pays a 30% rate of tax, they could effectively save about $7,700 per year in taxes by depreciating the cost of this building.
Now, imagine that it were possible to account for half the value of this building in the form of assets which are depreciable on a shorter, 5-year depreciation, term. In addition to the $3,850 per year that they could save in taxes based on depreciating $500,000 over the course of 39 years, that $500,000 in 5-year depreciation schedule assets (again, at a tax rate of 30%) could amount to an extra $30,000 per year in tax savings for the first 5 years of ownership.
In this way, cost segregation can act as a powerful tax shield for businesses who have recently made large real estate purchases. The ability to depreciate a portion of their new purchase over a shorter depreciation period can amount to thousands upon thousands of dollars in extra tax savings up front.
How are assets segregated?
Without going into more detail than would be practical for a blog post, let’s take a quick look at the ways that assets are generally segregated using this technique.
Generally speaking, a real estate purchase is broken out into several different asset classes, including:
- The land on which the building is located
- The building itself
- Improvements to the land
- Personal property located inside of the building
Breaking a large purchase down into these component parts doesn’t just result in potential tax savings on a shorter timeline: it also makes it easier to write off future replacements of individual components once current assets have lost their value. In other words, replacing piping or electrical wiring and depreciating the replacement is easier when it has already been singled out as an asset as part of a cost segregation study.
Certain aspects of a building can’t be broken down into individual component assets. Examples of these building components include things like the roof: certain items are a fundamental part of the building itself, and simply can’t be treated separately for depreciation purposes.
Once the maximum amount of a building’s value has been allocated to specific component assets as either personal property or improvements to the land (which are generally depreciable over either a 5/7 year or 15-year period, respectively), the next step is usually to assign as much of the property’s value as possible to the building itself. Anything left over is assigned to the land where the building is located. The reasoning here is simple: land is generally not depreciable, and you want to be able to depreciate as much of a property’s value as possible.
So, you’re convinced that cost segregation could be a source of massive tax savings for some of your clients. The question now is: how do you actually go about implementing this technique in order to put those savings into action?
Conducting a cost segregation study
In order to actually incorporate cost segregation into your client’s federal income taxes, you’ll need to conduct what’s called a cost segregation study.
The IRS has actually published a Cost Segregation Audit Techniques Guide. The introduction to this guide points out that number of segregation studies has increased sharply in recent years. In chapter 4 of this guide, the IRS specifically states that a quality cost segregation study is one which is conducted by a qualified individual with “experience and expertise.”
Considering that the IRS has created an audit guide specifically for this asset allocation technique — combined with the fact that they clearly state how important it is for the professional who conducts the study to have both expertise and experience that they can bring to bear on the task — it’s essential to take this process seriously. The IRS audit guide also mentions repeatedly that the study should be engineering-based, and that a study conducted by someone with an engineering background is generally deemed to be more reliable than one conducted by someone without any such background.
In addition to protecting your client from a potential audit, conducting a professional cost segregation study is important for ensuring that all eligible assets are accounted for separately and on a shorter depreciation schedule.
To sum up: actually implementing cost segregation effectively for a client involves conducting a study, and that study should ideally be conducted by a professional with engineering experience. Ideally, the person carrying out the study will have extensive experience with these types of studies in particular.
Is cost segregation right for my client?
This is a question that only you and your client can answer. If your client has the need to offset tax liability over the next few years so as to increase cash flow, taking this approach to asset depreciation could be highly beneficial for their business.
At the end of the day, you’ll want to delve deeper into the in’s and out’s of cost segregation before taking a client down this road. If you’re in one of the many states that requires annual CPE credits for accountants and tax professionals, consider signing up for CPE credit hours in cost segregation. Basics & Beyond™ offers some of the highest quality (and most affordable) CPE webinars available online: click here to see our upcoming schedule.