INVESTMENT: COST SEGREGATION
A tax-advantage strategy.
Cost Segregation is a strategic tax tool that allows companies and individuals to increase their cash flow by a process of allocating personal property to its proper tax classification. Many property owners will depreciate a building’s entire cost as real property using a 27.5 year straight line depreciation schedule, which is costly. Under the existing Internal Revenue Code, real property is depreciated over a period of 39 years for a commercial building and 27.5 years for a residential building. By using Cost Segregation, personal property can be identified and depreciated over five, seven or 15 years which reduces and defers investor income tax liability.
The advantages of using cost segregation became even greater in 2002. The IRS changed its rule for how it treats taxpayers who want to amend their taxes from earlier years using cost segregation. In the past, the IRS mandated that the benefits from the accelerated depreciation must be spread out over four years. Under the new rule, all the benefits can be taken in one year. Moreover, in 2002, President Bush signed the economic-stimulus bill that included a provision allowing taxpayers to depreciate 30% of any investment in one year as long as that investment would normally be depreciated in 20 years or less. This means that if a portion of a property’s costs can be classified as personal property or land improvements, they would qualify for the 30% bonus.
The savings to investors resulting from the use of cost segregation can help offset the taxes incurred by using free cash flow to aggressively pay off debt. Under the existing Internal Revenue Code, for every one million dollars’ worth of property reclassified from 39-year to 5-year property, the present value of tax savings is approximately $181,000 (using 35% tax rate and 8% discount rate). It also follows that every one million dollars’ worth of property reclassified as 7-year property results in approximately $165,000 of tax savings, and every one million dollars’ worth reclassified as 15-year property (site improvements) results in approximately $100,000 in tax savings.
Cost Segregation is regulated by a body of tax laws which must be strictly adhered to in order to avoid potential penalties. As well as adhering to tax laws, it is necessary to take into account applicable engineering principles and how different building components contribute to the business process. To ensure compliance with these regulations, Boutique Apartments engages an accounting firm to facilitate cost segregation studies.
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