A Publication of WTVP

Owners of commercial real estate can potentially lower their income tax obligations by using the benefits of IRS depreciation to their advantage. The practice of cost segregation is a way of lowering taxes by reclassifying real estate assets as personal property.

The building structure itself and "fixtures," which are traditionally considered "attached" or part of the structure of the building, have generally been considered real property and, as such, have been allowed by the IRS a depreciation period of 39 years. However, the IRS has allowed some fixtures to be treated as being separate from the building itself and, therefore, possibly reclassified as personal property, which depreciates over a much shorter period of time.

Each asset must be examined, and a critical question must be asked: is this a component part of the building or a separate asset? Although there are no exact rules that govern how much or what percentage of property within a building can be reclassified or "segregated" as personal property, there are guidelines that will help determine if it's a component part of the building or a separate asset. Most buildings easily consist of "personal property" assets that exceed 10 to 20 percent of the value of the property. The more specialized the building use, the higher the potential percentage of the personal property component. For example, a restaurant or manufacturing building could easily have 20 to 50 percent personal property.

According to property law, anything attached to a building or the land it sits on is part of the building. But these principles don't entirely apply in determining cost segregation. In determining which assets are parts of a building and which are separate, the "maintenance and operation" test is performed. Accordingly, fixtures that have to do solely with the maintenance and operation of the building-such as the roof, walls, wiring, and plumbing-are included as part of the structure. Just because a fixture is attached doesn't necessarily mean it can't be reclassified as personal property. The central question is whether the asset is necessary for the maintenance and operation of the building or strictly for the operation of the business that is conducted within the building.

Many personal property items are fairly obvious-stoves, refrigerators, and window air conditioners. These items clearly aren't critical to a building's maintenance or operation, and their cost can easily be segregated from that of the building itself.

Even items attached to the building can be classified as personal property if they're relevant to the business and not requisite to the operation and maintenance of the building. Depending on the specific asset, the length of the depreciation period can be reduced to as little as five years, which will result in a beneficial tax savings.

An accountant is usually equipped to perform a cost segregation study, but there are accounting firms that have individuals or departments dedicated to this function, and on larger properties, it would be advisable to seek their expertise in this area. It's important to be precise and thorough in the study to avoid IRS scrutiny and to maximize the benefits allowed. IBI