Be sure to consult your tax advisor as you plan the tax benefits of cost segregation. Owners of real property have faced limitations on the way they determine the allocation of tax basis in real property to deducible depreciation expense. Historically before 1981 real estate was allocated into components to qualify for investment credit. The Economic Recovery Act of 1981 repealed component depreciation but permitted 15 year life for building depreciation. The Tax Reform Act of 1986 increased the life of buildings to 27.5 for residential buildings and 39 years for non-residential buildings. After the 1997 tax case of Hospital Corp. of America the IRS agreed that cost segregation did not constitute component depreciation. IRS audit manuals and revenue procedures outline the requirements of a valid cost segregation report. In the April 2012, Journal of Accountancy, Larry Maples and Robert D. Hayes authored the Side Effects of Cost Segregation. In this article they suggest that your tax advisor should tally the pros and cons of cost segregation.
Shortened depreciation lives for part of a building will accelerate tax deductions but there may be unfavorable side effects of cost segregation. These side effects include, in taxable exchanges of cost segregated property, possible recapture under Section 1245. This recapture is subject to ordinary tax rates that could be higher than the 25% recapture rate for real property under Section 1250. Recapture can be a particular hazard for boot gain realized in like-kind exchanges. A further complication is that in a like-kind exchange components are grouped according to kind or class.
Bonus depreciation and cost segregation is often friendly to the taxpayer. The IRS has given liberal definition of “components” of self constructed property that qualifies for bonus deprecation. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provided for a new bonus deprecation of 100% or 50% depending on when the property was placed in service.
Cost segregation can complicate allocating costs to deductible repairs rather than capitalizing them. The IRS is scrutinizing accounting method change requests where the definition of “unit of property” may have changed. IRS audit technique guides reveal that the IRS believes some taxpayers are taking inconsistent positions when they segregate costs for depreciation purposes compared to when they deduct some costs as repairs or maintenance. The IRS audit technique guide states that a tax examiner should verify whether a new method of determining repairs is consistent with claimed dispositions. The underlying message is that taxpayers that use cost-segregation studies will have to live with their unit–of-property choices. The Maples and Hayes article concludes that the smaller the unit of property the more likely subsequent expenditures related to it will add to the value or appreciably extend the useful life of the property and the tax payer will need to capitalize the expenditure instead of expensing them as a repair.
Other possible considerations for taxpayers using cost segregation includes alternative minimum tax liability and cost segregations effect on the domestic production activities deduction.
Cost segregation is a permitted tax planning strategy. It has significant benefits but make sure you and your tax advisor consider these and other pros and cons as you plan the tax impact of holding real property.