Purchasing new fixed assets can be a paradox. The asset may increase the value of the business, but the business may have to expense that cost slowly over 27.5 or 39 years rather than receiving an immediate deduction. For purchasers of buildings, however, there may be a work-around: cost segregation. Cost segregation is the practice of accounting for as much of the fixtures, improvements, and other property within a building separately from the building itself. By separating the assets, it ensures that the taxpayer is able to take advantage of accelerated depreciation allowed for each class of assets.
The statutory basis for cost segregation related topics is found in three sections of the Internal Revenue Code—sections 1231, 1245, and 1250. Section 1231 governs recapture of depreciation generally, while sections 1245 and 1250 provide specific rules for particular types of property.
Section 1245 governs personal property used in a trade or business and distinguishes gain that will be treated as ordinary versus capital. Specifically, gain on depreciated qualifying property may be treated as ordinary to the extent of the depreciation taken, with the remainder being treated as capital. Section 1250 governs real property like buildings, structures, and components. Importantly, this definition could include non-real components such as furniture and fixtures. This ambiguity is the basis of cost segregation.
More technically defined, cost segregation is the process of segregating the purchase price of a building into the building itself—section 1250 property—and its non-real property fixtures, improvements, and other property and then treating this asset group as section 1245 property. This segregation maximizes the assets for which accelerated depreciation can be claimed, shorter depreciable periods can be used. Consider the shrewd investor Oliver Owner who purchased an apartment building for $2,000,000. Shortly thereafter, he retained counsel for a cost-segregation study. As a result, he ascertained the value of the appliances, beds, carpet, decorative lighting, and other fixtures and improvements as $250,000 and noted that this property is subject to section 1245, not section 1250. Fortunately for Oliver Owner, that property was eligible for bonus depreciation, so he was able to claim a $250,000 deduction in the year of purchase. The remaining property would continue to be depreciated over the regular 27.5 year period.
Cost segregation do, of course, involve some risk that the IRS will disagree with the results of the study. This risk may be mitigated by avoiding certain red flags. The first and most notable is to ensure that the terms of the original purchase contract did not preclude a cost-segregation study in the first place. Some sales contracts may, by its own terms, allocate the entirety of the purchase price to the building and the land as agreed to by both the buyer and the seller. From a seller’s perspective, they would want as much of the purchase to be allocated to land and building to help their own depreciation recapture position and may have the buyer agree that they are buying just the building and land via a binding contract. On the other side, the buyer may want to avoid such an agreement so they can claim section 1245 property. Following such a sale where the seller dictates the purchase is for building and land, the new owner may not have any basis in claiming section 1245 property and thus the property would be only building, subjected to longer depreciation period and no bonus, and land, which cannot be depreciated. The second red flag to avoid is a short holding period. In general, an owner should plan on holding the subject building for at least three years if they want to engage in cost segregation. Any shorter, and the IRS is more likely to determine that the section 1245 property still had value at the time of sale.
member center
