"Component Depreciation With Real Estate"
The phrase component depreciation has often been used interchangeably with cost segregation. But, in fact, the two are very different. While the results may be similar, the methodology is completely different. In this post, we compare and contrast the different methodologies.
Component depreciation was used extensively in the 1970s and early 1980’s. But that all changed during tax reform of 1986.
Component depreciation largely focused on separating out all the systems of a specific building or parcel of real estate. This would include electrical systems, roofing, and plumbing. These components were then depreciated over a shorter life than traditional depreciation methods.
Accordingly, the depreciation of the individual components resulted in substantially higher depreciation write-offs compared to depreciating the entire building as a whole.
Component Depreciation: How Did it Work?
Before 1981, we did not have objective statutory recovery periods as we do now where you must use 5, 15, 27-1/2, 39, years (etc.), regardless of the age or condition of the property. Before 1981, we used “estimated useful lives” which were based on judgmental, subjective factors such as the age, construction-type, condition and location of the property.
Thus, a building may have had a useful life of 25 to 50 years depending on these factors. Back then, component depreciation was a method that was used to increase depreciation deductions by “componentizing” (or breaking down) a building into its real structural components and then depreciating each structural component with a lower useful life.
For example, a building shell may have an estimated useful life of 35 years. But its allocated components may have a lower useful life as follows: Electrical – 10 years; plumbing – 12 years; roof – 20 years; heater – 15 years, etc. By depreciating each building component over each one’s lower useful life, you were reaping larger depreciation deductions.
When you mention component depreciation, some people (including tax practitioners) will say “component depreciation is no longer allowed.” Technically they are right, but they misunderstand what we are doing here. While there may not be any more component depreciation, there is still componentizing. What’s the difference?
Cost Segregation: How Does it Work?
Under today’s Modified Accelerated Cost Recovery System (“MACRS”), we do not use estimated, arbitrary useful lives. Instead we use the preset statutory recovery periods of 5, 15, 27-1/2, 39 years. Consequently, we cannot use “component depreciation” with different useful lives as per the above. However, provided we use these required recovery periods, we still can componentize to attain substantial tax savings.
Although it is a subject of much debate, perceptions existed that component depreciation had been used abusively. Once tax reform came along, component depreciation was eliminated and there was no legitimate process to “break out” real estate for approximately a decade.
Then a landmark case came along. It was called Hospital Corporation of America. This case established the basic boundaries of cost segregation. Cost segregation then the focused on interior improvement‘s and land, while component depreciation was concerned with the building systems.
Land improvements were allowed to be segregated as well. This included items such as landscaping, asphalt, curbs, and sidewalks. Interior improvements that were eligible for a shorter depreciation life included carpet, tile, wall coverings signage, and certain plumbing and electrical equipment.
As of results of the case, the IRS developed a manual to guide IRS auditors, CPAs, appraisers, and the resulting industry of cost segregation consultants. The goal of the IRS manual was to provide practitioners a roadmap for real estate cost segregation studies. The manual defined what items qualify for 5 year, 7 year and even 15 year depreciation lives. This IRS manual became a safe harbor for taxpayers.
A well constructed and authoritative cost segregation report what outlined possibly 20 to over 100 items that could qualify for depreciation under a shorter life. In contrast, a component depreciation analysis might have only included 5 or 10 building systems.
The IRS looked for qualified specialists to prepare the cost segregation studies and resulting depreciation schedules. The reports could be completed when the building was initially purchased (or constructed) or even multiple years down the road if the owner wanted to restate the depreciation to adjust for under-reported depreciation items.
The end result is that cost segregation is the current version of component depreciation. It may even result in depreciation that is similar. But it is not the same thing.
Component Depreciation Real Estate
Not every commercial building should have a cost segregation analysis done on it. That is because some real estate properties are operating at a loss before accelerating depreciation. If that is the case in why spend money on a cost segregation study when it will not result in a tax savings. In fact when dealing with real estate potential passive losses there are many situations when an increased loss will not result in any tax savings.
So it really makes sense to consult with your tax advisor for you order a cost segregation study. When talking with the CPA, or tax preparer question that should be asked is do I need to increase my real estate losses.
Cost segregation studies can be different based on who is involved with the details of the engineering plans of the building being analyzed. As opposed to the preparation of many business returns that can be fairly cut and dry, a cost segregation analysis is more of an art than a science. At the same time being to aggressive good result in the cost segregation study being subject to scrutiny and deductions could be disallowed.
Keep in mind that the order process occurs often many years later, which means that in addition to the tax burden that could be increased there is also a possibility of penalties and interest. This is why want an expert that will take a synthesis of an approach to maximize deductions while minimizing the possibility of raising audit flags.
It pays to ask the engineers and accountants will be preparing study what their methodology is in the process that they follow. In addition there should be an approach that will include a review of the items being segregated and reclassified.
Consider the paper clip. This useful office implement can actually save you money on taxes owed for your commercial property. While this may seem like an outlandish prospect, cost segregation can translate into unbelievable savings come tax time by separating personal property assets from real property assets.
What Is a Cost Segregation Study?
When undergoing a cost segregation study, property owners work with familiar with the process to identify certain assets that can be reclassified, increasing the available tax deductions. This can include items within a given property, as well as costs related to the land improvements surrounding a structure, and more.
The core principle of such a study involves accelerated depreciation. This enables property owners to speed up the write-off process by reclassifying certain items – such as the aforementioned paper clips – to faster depreciation schedule. This process can effectively reduce tax liability, which is especially important in the years immediately following an investment.