As many of my small business clients know, Section 179 expensing dropped significantly to $25,000 beginning in 2014 and Bonus Depreciation expired. These deductions were very popular tax strategies my small and midsize business clients used to keep more money in their pockets. With these not being available I have been recommending an old but little known tax strategy - Cost Segregation.
The Basics of Depreciation
Before we get into the details of Cost Segregation, let's talk about depreciation. Depreciation is an annual income tax deduction that allows you to deduct the cost or other basis of certain property used in trade or business over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property. Depreciation can occur over 3 - 25 years for tangible personal property (equipment) or 27.5 - 39 years for real property (land and buildings).
So.... What is Cost Segregation?
Cost segregation is a valuable tax strategy which views real property (land and buildings) used in business or trade not just as a building and land, but also as land improvements and elements of tangible personal property (equipment). The tax advantages and related tax savings come from accelerated depreciation deductions that defer tax and improve cash-flow. The result of cost segregation does not mean you are getting any extra depreciation - it just means you are speeding it up and receiving it sooner.
How to Take Advantage of Cost Segregation...
A cost segregation study must be completed by a reputable engineering or consulting firm in order to find the personal property components of a building. This study will identify certain portions of what would typically be considered part of a building, and break them into tangible personal property assets with shorter depreciable lives. The depreciation on items such as sidewalks, parking lots, specialty plumbing and electrical, carpet, etc can then be accelerated over 5 to 15 years instead of 27.5 or 39 years.
What to Watch Out For...
As mentioned, this tax strategy only acts to accelerate your depreciation deduction. In the beginning, you are able to take a higher deduction which will reduce your taxable income therefore reducing your taxes. In the future, your deduction will be lower and taxable income more. Also, if you decide to sell an asset for more than its depreciated value you will need to deal with recaptured depreciation - basically the IRS will tax your depreciation "profits" as income.
On another note, with proper planning business owners and investors can combine Cost Segregation with a 1031 Exchange to maximize their tax benefits. Both of these valuable tax strategies can be used to defer taxes, improve cash-flow, be done on the same property and can be done on any type of commercial property. Both will require the help of specialists though - an engineering firm for the Cost Segregation study and a Qualified Intermediary for the 1031 Exchange.