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Cost Segregation: Money Doesn't Grow On Trees...But It Could Be Hidden In Walls

By Ralph Consola and David Zaslow

What would you say if someone offered you a dollar in exchange for a dime? What if your accountant said there was a service that would return $1 in tax savings for every 10¢ you spent on the service? If you're like most fms, you'd say, "What's the service called, and where do I sign up?" It's called "cost segregation," and it brings IRS-recognized tax savings to building owners concerned with conserving cash.

A cost segregation analysis maximizes a building's tax benefits by identifying, classifying, and segregating a building's assets for accelerated depreciation for Federal income tax purposes. And while it's generally understood that carpeting and cabinets may be identified as personal property in order to obtain the increased tax deduction associated with shorter depreciable lives, this typically amounts to less than 3% of a building's component costs.

Meanwhile, the remainder of the facility is assigned a depreciable life of 39.5 years–in spite of the fact that other building components may also be eligible for the increased tax deduction. But if a building undergoes a cost segregation analysis, fms may uncover a significant sum more than 3%. It may even translate into three, five, or sometimes even 20 times more savings than the 3% found in cabinets and carpeting.

What's Eligible?
Here are just a few of the items that a cost segregation specialist looks for when working to identify tax savings in a building.

• Is there more than one power outlet in your office?
• Do the walls in your office penetrate the ceiling tiles?
  
• Is the decorative paneling in your reception area and conference room glued, nailed, or hung on the wall?
  
• Is your cooling system oversized in order to cool your data processing room?
  
• Do you have a kitchen?

Cost segregation specialists perform a non-intrusive, yet detailed engineering study of a building's walls, flooring, ceiling, plumbing, electrical, lighting, telecommunications, heating, and cooling systems. Next, assets are grouped under several accelerated depreciation rate (ADR) classifications.

The cost segregation professionals then identify which components of each system that, according to Federal Tax law, can be assigned accelerated tax lives of five, seven, or 15 years (in contrast to the straight-line 39.5 years). These resulting tax savings drop right down to a company's bottom line in the form of tax liability reductions.

Careful Scrutiny
In order to get the most accurate sense of these various systems, cost segregation professionals work from accurate building plans and good cost documents rather than strictly relying on a physical building tour. This "behind the scenes" examination can provide the maximum benefit, since it makes the facility walk through much less labor intensive. It's also a better way to identify those building components eligible for short-term depreciation categories.

Fms should note, however, the importance of accurate documentation. Good cost documents allow the analyst to steer clear of national cost manuals–typically lower than actual costs–to arrive at the true prices of building components.

Having correct cost documents and plans means a better fee for service since the cost segregation professionals won't need to spend as much time on the assignment. It also usually translates into higher savings for the client.

The Sooner The Better
Cost segregation studies should be initiated as early as possible in the construction or acquisition process to obtain maximum savings. Consider these three points:

1. If given 10 minutes with the architect before the design of a building begins, a cost segregation professional can show the architect how to make a larger percentage of the building's components qualify for short-term depreciation, thereby increasing the tax savings for the building owner.

2. Building components should be special ordered. For instance, granite counter tops on a reception desk, special chandeliers, window coverings, and other custom components usually have a higher cost than items found in national catalogs.

However, there must be proof of these costs in order to report the higher value to the IRS. Furthermore, it is often more difficult to track down cost documents as the construction process moves along. If granted access to the construction chief before the project breaks ground, a cost segregation specialist will request that the cost of five to 10 items be set aside for reporting.

3. If a cost segregation study can be performed before the building is actually acquired, personal property can accurately be separated from the building costs. The two costs can then be broken out in the sales agreement and the real property transfer tax basis can even be reduced.

Great savings are still available once the project or the acquisition is complete. In many cases, the deductions can still be taken years after the project is complete. But why wait? As the old saying goes, time is money.

–David Zaslow and Ralph Consola
Zaslow, CPA, is a founding partner of Los Angeles, CA-based RBZ, LLP, an accounting and strategic business consulting firm. Consola is a vice president at Marshall & Stevens, a Los Angeles, CA-based financial consulting firm that provides cost segregation studies in affiliation with RBZ.