Apr 15

Are the net benefits of cost segregation worth it? A simple case study.

Cost segregation has the effect of increasing depreciation deductions which in turn reduces taxable income, and in turn minimizes taxes paid and maximizes cash flow. This article explores the business case around cost segregation by way of a simple example.

So, if a business, or business owner, in the 35% tax bracket can increase depreciation deductions by, say, $10,000, that has the effect of reducing taxable income by $10,000…the end-game effect is that $3,500 less will go to the IRS (and $3,500 more would go to a business’ cash flow).

Cost segregation is a tax deferral strategy which 1) identifies, 2) separates and 3) classifies tangible real property assets into their shortest depreciable life (recovery period) allowable for each building component.

In more detail, cost segregation increases building depreciation deductions when assets that are depreciating based upon a, say, 39-year usable life, can be reclassified (where allowable) as assets that depreciate based upon a, say, five-year recovery period.

It isn’t uncommon to have personal property with 5 to 7 years worth of usable life classified as 39-year straight line (S/L) depreciation items; building components such as affixed cabinets, un-affixed floor coverings, and electrical components servicing equipment. Further, assets with 15 years worth of usable life can be classified as 39-year S/L depreciation items as well; such as parking lots, storm drains, sidewalks, and storm drains.

What would be the tax implications of classifying the entire property as 39-year S/L versus the effort to segregate and reclassify property components into recovery periods between 5 and 15 years?

Let’s compare; starting with the 39-year S/L depreciation on a $1M building example, we would be able to deduct $25,641 per year.

Suppose 15% of this example $1M (not including land cost) specialized office building (medical, laboratory, research, etc.) was classified as property with a five-year recovery period and 10% was classified as 15-year property. So, $150,000 of 5-year property would allow for $30,000 per year in depreciation deductions and the 15-year property would allow for $6,670 in annual depreciation deductions.

So, the annual difference between the depreciation deduction scenarios would be $36,670 – $25,641, or $11,000. This translates into paying $3,860 less in annual taxes over the next five years, for a difference in paying $19,300 less in taxes.

This monetary difference after five years between the two building depreciation paths allows for a business to have cash on hand to help replace those 5-year life building components, especially if the cash difference was invested for a modest 4% annual return to help keep up with, or ahead of, inflation.
And, please note, the benefits of cost segregation can be realized (both retroactively and going forward) even on properties purchased several or more years ago.

The cost segregation work required to classify property as favorably as possible does come with a cost – like any business decision, that cost has to be weighed against the benefits. We invite those interested in considering the net benefit after accounting for cost segregation fees to contact us for a free (conservative) analysis of your tax benefits and a quote to do the work so you can make an informed decision.