Cost segregation is the process of identification and separation of personal property assets such as equipment, furniture & fixtures and certain leasehold improvements from real property assets such as buildings.
The purpose of cost segregation is to identify the personal property assets in order to shorten the length of time those assets are depreciated for tax purposes. This length of time is called the recovery period. The shorter recovery period will result in an increased depreciation deduction over a shorter period of time. The classification of the assets as personal property also allows a depreciation method to be used (referred to as MACRS depreciation) that provides for accelerated depreciation in the initial years the asset is owned. Cost of personal property assets is also eligible for 100% deduction under Internal Revenue Code Section 179 if certain conditions exist.
If no segregation is made, the personal property assets will be depreciated over the longer recovery period that is required for buildings. The depreciation recovery period for residential buildings is 27.5 years and 39 years for commercial buildings. In comparison, the depreciation recovery periods for most furniture and fixtures are 7 years, equipment is 5 years and certain exterior site improvements such as sidewalks and landscaping may be depreciated over 15 years.
Identifying the components may be difficult. An example of this would be when an existing building is purchased by the taxpayer. In these instances, a formal study may be performed to identify the individual components and the cost to be allocated to those components.
These formal studies are generally performed by specialists with expertise, industry experience and specialized training. These studies are not only performed for tax purposes but may also be used for financial accounting, insurance and property tax purposes. A formal segregation report should always include the following:
1. Classification of assets into property classes (e.g., land, building, building improvements, equipment, furniture and fixtures);
2. Explanation of the rationale for classifying assets as either personal property assets or real property assets; and,
3. Substantiation of the cost basis of each asset and reconciliation of the total allocated costs to actual total costs.
The length of time the taxpayer plans to own the building will be a factor when considering if a formal cost segregation study should be performed. If the taxpayer plans on holding the building for an extended period of time, the cost of the study may benefit the taxpayer. Cost segregation studies will also be more important in the future as the IRS new repair regulations issued in 2012 begin to take effect.