For tax purposes, the Internal Revenue Service allows the value of a commercial structure to be depreciated over a period of 39 years. Those yearly depreciation amounts are a deductible expense. But some assets within the structure—such as carpeting, lighting, and cabinetry—have shorter useful lives, so they can be depreciated faster—typically over five to seven years. Using an accelerated depreciation schedule on those items can enable you to keep more of your money in the critical early years of a building’s lifespan. With a large property, the upfront tax savings can be considerable. 

Isolating those assets that can use an accelerated depreciation schedule, and calculating the financial impact of each, is known as cost segregation.

Like many building owners, you may choose to take advantage of the increased early deductions available with accelerated depreciation. With the cash you retain, you might invest in the growth of your business or pay off your mortgage loan. If you intend to sell the building within a few years, you might benefit from the reduced tax liability now. And if you’re hoping to expand your portfolio in the short term, you can use the cash for that purpose. 

On the other hand, if you don’t need the cash now and plan to hold the building for the long term, then straight line depreciation can preserve your tax benefits over a longer period.

Another factor to consider is the potential impact of the depreciation recapture tax, which owners often face when they sell their property. The IRS regards the deductions taken for property depreciation as capital gains, which is therefore subject to taxation when the property is sold. For instance, if you’ve bought a property for $500,000 and sold it for $700,000, you’ve made a gain of $200,00. But if you’ve claimed depreciation of $100,000 during the years you owned it, the IRS regards the depreciated value (i.e., the basis) of the property as $400,000. So, your taxable gain is $300,000. This comes as an unwelcome surprise to some sellers, who have trouble understanding why they’re being taxed on income they never saw. But it’s a reality that can’t be ignored. 

One way to avoid this liability is by completing a 1031 exchange. In this process, rather than selling a property and keeping the gains, an owner uses the sale proceeds to buy another property–exchanging like property for like. When done properly, this eliminates the capital gains tax liability on the sale of the first property.

It should be clear that these are all complex matters requiring expert help. This is why it’s smart to commission a cost segregation study to sort out the financial implications of each depreciation strategy. And the best time to do that is early in the process—ideally before building begins. But it can be done at any time while you own, or are thinking of owning, a property. It’s never too late or too early to formulate a sound financial strategy.

A cost segregation study can help you isolate the assets that qualify for accelerated depreciation and determine the appropriate depreciation schedule for each. Most importantly, it can show you the expected financial outcomes from the various available approaches. In the cost segregation studies Fleming Construction Group has conducted for clients, we’ve often been able to identify net present value (NPV) benefits up to 30 percent of building cost in the first five years of implementation. 

The key to cost segregation is identifying assets that could be classified as movable or personal property rather than essential components of the structure, which are considered real property. In addition to the previously mentioned carpeting, lighting, and cabinetry, these items may include:

If an asset serves a specialized function that wouldn’t necessarily be useful to subsequent owners, it may also be eligible for accelerated depreciation. For instance, a conventional air conditioning system would be considered part of the building’s essential functions, so wouldn’t be eligible. But an air conditioning system designed specifically to protect certain equipment would be. An important differentiator is whether an asset or system is designed to serve people—which would be applicable to any occupants—or equipment. These are the types of distinctions that a cost segregation study will help define. 

Improvements to the land that are not part of the building itself can also be depreciated on a 15-year schedule. These may include:

Your cost segregation team may include experts in real estate finance, tax law, real estate appraisal, and engineering. The team should also include someone from the construction industry who brings firsthand knowledge of the various components of a complex structure. The study itself may take several weeks to complete. 

Predictably, there are now numerous software applications available to help in producing cost segregation studies. The best ones can quickly identify eligible assets and produce customizable reports to help the owner chart the best course. But as with most complex issues, there is no substitute for humans with specific expertise who can make judgments based on knowledge and experience.