Cost Segregation: Improving ROI on major capital investments
Yet many business owners don’t know that an underused tax strategy called a cost segregation study (CSS) can translate major upgrades into improved short-term cash flow and long-term financial strategy.
A CSS can improve return on investment by shortening depreciation lives for certain real estate investments from the usual 39 years to as low as five years. In some cases, additional tax provisions may exist allowing for immediate deduction. It offers significant tax benefits, but the process can be complex, leading to one basic question: Is a CSS right for my business?
Cost Segregation Study: The basics
CSS re-characterizes some of the costs to five, seven, or 15 years, helping taxpayers front end load depreciation and pay less tax during the early stages of a property’s life.
The CSS allocates certain costs of a newly built, purchased, or renovated building to personal property or land improvements that are assigned shorter depreciation periods. The study is also useful for depreciable real estate that has passed through an estate. The process involves the identification of various building components such as electrical, plumbing and mechanical components whose primary purpose is to support business property with shorter depreciation lives. Once identified, the related costs can be reclassified to five, seven or 15 year property.
Is a CSS right for my business?
A CSS requires the engagement of tax specialists and engineers, so it’s not inexpensive and it doesn’t fit every situation. However, a CSS can offer a major opportunity to reduce income tax liability and improve cash flow.
These three questions can help a business determine if a CSS is warranted:
- Is the property suitable? The answer depends on the initial investment ($750,000 or more), and what the real estate is used for. A warehouse contains less specialized equipment therefore it would have fewer costs eligible for shorter depreciation. However, a complex structure such as a hospital, manufacturing plant, restaurant, grocery store, auto dealership or hotel would typically result in a substantial amount of property being reclassified. Depending on the related business purpose of the real estate, it is not unusual for 35 percent of the investment (meaning $350,000 worth of property in a $1 million building) might be reclassified to less than 39 years.
- What are the savings? The answer depends on the type of real estate and the depreciation laws in place. An average net present value of tax benefits through CSS ranges from 4 percent to 8 percent of total facility costs, excluding land. In those cases, a $1 million investment could reach a tax benefit of $40,000 to $80,000, and sometimes much more.
- Does CSS make sense for all property owners? Not necessarily – the owners need to understand their unique tax situation, the potential accelerated depreciation deductions as well as the underlying cost of the study to determine their personal tax benefit for the study.
Some businesspeople mistakenly believe that a CSS can be performed only when filing for the tax year when the investment was made. However, businesses that made large investments in recent years but didn’t segregate costs can go back and take those deductions.
In the absence of a CSS, an investment in buying, building, or renovating commercial property defaults to a statutory depreciation life of 39 years. Often, the time and expense needed to conduct a study and reduce that depreciation are resources well spent. A CSS can help launch business ventures on firm financial footing.
Daniel P. Thompson is a principal at Boyer & Ritter LLC and chair of Dealership Services Group and provides accounting, auditing, tax and business consulting to clients in a variety of closely held businesses. He can be reached at 717-761-7210 or firstname.lastname@example.org