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Saturday, March 1, 2008

Newsletter Archive- Cost Segregation Study

What is a cost segregation study? (Part 2) - Bob Durfey, PE, EnviroMed Design Group

A cost segregation study separates the costs of a building into various class lives to establish depreciation schedules for income tax purposes. The study may also be used for determining insurance requirements or to validate (or invalidate) property tax assessments. The conclusions of a study cannot be relied upon to avoid IRS penalties. To best grasp cost segregation, one needs to know about and understand depreciation and how the Tax Code has evolved over the last 20 years to where it is today.

IRS Publication 946 defines depreciation as "an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property." The key to depreciation is "over the time you use the property." Being able to allocate a shorter "time of use" to an item will provide larger depreciation amounts sooner, and thus more deductions for income tax purposes. It is to be noted that taking a larger depreciation sooner means that the deductions will be used up sooner. The advantage is that there is earlier use of the money from tax savings.

The tax codes in force during the 70's and early 80's provided tax benefits for building owners by establishing shorter and/or accelerated depreciation schedules for items that were deemed non-structural elements of a building. This component depreciation breakout also provided investment tax credits for some of these items that were deemed to be personal property. Then along came the Tax Reform Act of 1986.

The Act eliminated component depreciation and established recovery periods which placed non-residential real estate into a 39 year category with land improvements generally in a 15 year category. This was the system in use until the Hospital Corporation of America brought suit against the IRS in 1997 to restore a form of component depreciation by allowing property to be classified either as section 1245 or section 1250 property. Section 1245 property is personal property such as furniture, fixtures and equipment.

The HCA ruling allowed certain related systems such as plumbing and electrical items that support FF&E to be considered 1245 property. It excludes a building and it's structural components. Section 1250 property is everything else excluding land and land improvements.

Confusing? You bet! Check out the newsletter archives where the methods, qualifications and format of a study will be covered.

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