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Tax Benefits of Cost Segregation

May 31, 2022

Business and individual taxpayers that own nonresidential real property or residential rental property have an opportunity to reduce the depreciable lives on assets which are building components. Classification of building components as personal property will save federal taxes and increase cash flow by accelerating depreciation deductions that reduce income taxes during the early years of a building's recovery period.


The identification and separate depreciation of personal property components and land improvements is referred to as "cost segregation." These items of personal property and land improvements, along with their depreciable cost-basis and recovery period, are identified in a formal document referred to as a "cost segregation study." Cost segregation studies are most prepared for the allocation or reallocation of building costs to tangible personal property.

A building, termed "§ 1250 property", is generally non-residential real property (39-year) or residential rental property (27.5-year) eligible for straight-line depreciation. Equipment, furniture, and fixtures, termed "§ 1245 property", are tangible personal property. Tangible personal property has a shorter recovery period (e.g., 5 or 7 years) and is also eligible for accelerated depreciation (e.g., double declining balance, bonus depreciation and § 179 deduction). Therefore, a faster depreciation write-off and tax benefit can be obtained by allocating property costs to § 1245 property.

Property classification rules

Property is typically separated into individual components or asset groups having the same recovery periods and placed-in-service dates to properly compute depreciation. The recovery period for an asset is usually determined based on the type of business in which the taxpayer uses the asset. Under MACRS (Modified Accelerated Cost Recovery System), recovery periods are assigned as below:

  • Non-residential real property—39 years

  • Residential rental property—27.5 years

  • Land improvements—15 years

  • Office furniture and equipment—7 years

  • Computers and related equipment—5 years

  • Automobiles, light trucks—5 years

The property class for most property is prescribed by the IRS in a table contained in Rev. Proc. 87-56. If a particular asset is not listed in the first part of the table, then its property class and recovery period are determined by the business activity in which the asset is used.

The business activity is determined by reference to the person using the building, for example, the tenant. If the business activity of the taxpayer is not listed in the revenue procedure or the assets listed for the business activity do not include personal property elements of a building, then the property is treated as 7-year MACRS property. This is the default classification for personal property with no class life.

Tax Benefits of Cost Segregation

Building components identified as personal property will be depreciated using the 200-percent declining balance method over a five- or seven-year recovery period. Many taxpayers mistakenly include the cost of such components in the depreciable basis of the building and the cost is recovered over a longer depreciation period.

Some examples of building components include: parking lots, sidewalks, curbs, roads, fences, storm sewers, landscaping, signage, lighting, security and fire protection systems, removable partitions, removable carpeting and wall tiling, furniture, counters, appliances and machinery (including machinery foundations) unrelated to the operation and maintenance of the building, and the portion of electrical wiring and plumbing properly allocable to machinery and equipment that is unrelated to the operation and maintenance of the building.

The tax savings are further enhanced if the personal property components also qualify for bonus depreciation or the Code Sec. 179 expense allowance.

Code Sec. 179 Expense Allowance

Personal property components of a commercial building identified in a cost segregation study can qualify for the section 179 expense allowance. The maximum deductible amount (dollar limitation) under Code Sec. 179 is ($1,050,000 for tax years beginning in 2021 and $1,080,000 for 2022).

The dollar limit is reduced by the cost of qualifying Code Sec. 179 property placed in service during the tax year in excess of the investment limit amount. The investment limit for property placed in service in tax years beginning in 2021 is $2,620,000 ($2,700,000 for 2022). Thus, section 179 expensing is not available to larger taxpayers. However, the expense allowance can represent a significant tax savings factor for qualifying taxpayers when analyzing the benefits of conducting a cost segregation study on a commercial building.

Bonus Depreciation

Section 1245 building components identified in a cost segregation study qualify for the bonus depreciation deduction if the taxpayer could have claimed bonus depreciation on the components when the building was originally placed in service by the taxpayer.

In general, this means that bonus depreciation can apply to section 1245 components if the taxpayer placed the building in service after September 10, 2001, and before January 1, 2005, or after 2007 and before the scheduled expiration of bonus depreciation. Rules which disqualify property subject to binding contracts or property acquired prior to September 10, 2001, or between January 1, 2005, and December 31, 2006, may apply to disqualify the components from bonus depreciation.



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