- Cost segregation is a tax planning technique that accelerates depreciation deductions for real property by reclassifying elements of a building as tangible personal property eligible for MACRS depreciation. The technique may be advantageous when the discounted value of the tax savings exceeds the costs of its implementation.
- One potential pitfall of cost segregation is its impact on a later exchange of the building for like-kind property. Generally, a taxpayer recognizes no gain or loss in a like-kind exchange of real estate. The creation of multiple asset classes makes it likely that gain will be recognized in an exchange that otherwise would be nontaxable, which may largely offset the initial benefits of cost segregation.
- When a client is contemplating cost segregation, the tax adviser should discuss with the client the potential for an exchange of the property and incorporate an exchange in the analysis when appropriate. Failure to do so can lead to an unexpected and unfortunate tax and cashflow result. What a taxpayer gains in accelerated depreciation may be more than lost in a like-kind exchange.
Cost segregation is a popular tax planning technique for owners of depreciable real property. While it is a legitimate and sometimes beneficial technique, some taxpayers have adopted it without considering the potential adverse consequences that can occur upon disposition of the property. In particular, taxpayers and their advisers should be aware that cost segregation can result in later recognition of gain in a like-kind exchange of the property when gain otherwise would not have been recognized.
Cost segregation, also called componentization, reduces tax by accelerating depreciation on components of a building. Depreciation is accelerated by reclassifying components as 5-, 7-, or 15-year modified accelerated cost recovery system (MACRS) property rather than 39-year straight-line real property. This technique was revitalized in the case Hospital Corporation of America,1 in which the court allowed the taxpayer to categorize assets in a hospital into many classes depending on their separate lives based on whether the assets could be removed from the building and a number of other factors (discussed below). Assets such as lighting systems, movable walls, and ceiling grids were determined to be separable from the real property or supporting a separable activity and thus eligible for accelerated depreciation.
Examples of 15-year property include outdoor lighting, signage, and landscaping. Typical 7-year assets include floor and window coverings, decorative millwork, and electrical fixtures. Some assets identified in a componentization study may qualify for Sec. 179 expensing and/ or bonus depreciation, which could further accelerate depreciation. These assets are not generally those that would be treated as personal property in a like-kind exchange as would appliances and other freestanding equipment.2
Like-kind exchanges under Sec. 1031 allow a taxpayer to defer recognition of realized gains when exchanging property for like-kind property. Because of the broad definition of “like-kind” real estate, this technique is especially valuable to owners of commercial and residential rental real estate. In fact, Sec. 1031 has spawned an entire industry of specialists who broker transactions and serve as qualified intermediaries in exchanges.
Similarly, componentization has caused the creation of firms that value buildings by asset class as well as advise on proper lives and potential future taxation. They evaluate a building and segregate its components into parts or segments that normally are thought of as integral but could be considered removable and able to be categorized into depreciable classes.
This article focuses on the interaction between these two tax deferral methods.
Under Sec. 1031(a)(1), in general “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” Regs. Sec. 1.1031(a)-1(b) defines “like-kind” as referring to the nature or character of the property and not to its grade or quality. A taxpayer may not exchange one kind or class of property for property of a different kind or class.
Regs. Sec. 1.1031(j)-1 requires that the taxpayer group multiple properties exchanged in a like-kind exchange into “exchange groups” of like kind or like class. The taxpayer then computes the gain to be recognized on the exchange and the basis for the assets received in reference to the fair market value (FMV) of the exchange groups. An exchange group may consist of properties within the same general asset class or product class. Additional rules for exchanges of personal property are enumerated in Regs. Sec. 1.1031(a)-2. A taxpayer may determine “like kind or class” by reference to either the general asset classes provided in Regs. Sec. 1.1031(a)-2(b)(2) or the North American Industry Classification System (NAICS) product classes.3
Under Sec. 1031(d) regarding basis, if property was acquired in an exchange described in Sec. 1031, the basis is the same as that of the property exchanged, decreased by any money or other nonqualifying property received (boot) and increased or decreased by any gain or loss recognized. Boot property takes a basis equal to its FMV. It is important to note that cost segregation, by creating multiple classes of assets, increases the complexity of basis calculations. This determination of basis becomes very important when a taxpayer exchanges real and personal property simultaneously. Recent regulations have clarified the rules for depreciation of property acquired in a like-kind exchange.4
If the taxpayer has constructed the building and kept adequate records, the cost of each component is easily found. If the taxpayer has purchased the building, however, establishing the cost of each asset group may require estimating or allocating costs to each group. It is important that a qualified professional performs such a cost segregation study. The IRS has stated that individuals or firms qualified to segregate costs include those competent in design, construction, and estimating procedures as well as the applicable tax rules.5 The client can then determine whether the net present value of the resulting tax savings warrants changing the depreciation method for building components that can be classified as Sec. 1245 property. Firms specializing in componentization studies typically charge at least $5,000 and go up rapidly from there. Some firms bill time and costs, and some bill a percentage of the “tax savings.”
The taxpayer takes the additional depreciation (often called catch-up depreciation) as a Sec. 481 adjustment. The Code allows the deduction to be taken in one year by filing Form 3115, Application for Change in Accounting Method. Under Rev. Proc. 2008-52,6 a taxpayer may request automatic consent for the change. At one time the IRS routinely denied the automatic consent, making the outcome of the claim uncertain. The Service has since moderated its position, making cost segregation a more feasible planning mechanism.
Asset Classification Tests
In Hospital Corporation of America, the Tax Court substantially upheld the Sec. 481 adjustment claimed by the taxpayer and allowed it to treat a variety of components of hospital buildings as nonreal property for depreciation purposes. Such assets included floor and wall coverings, partitions, handrails, and elements of the electrical and water systems.
The court relied heavily on a 1975 case, Whiteco Industries,7 in which an outdoor sign advertising company successfully claimed an investment tax credit on outdoor advertising signs. While the case dealt with a different aspect of the Code and not cost segregation, the underlying issue was the same: whether something qualifies as tangible personal property as opposed to real property. The Tax Court in Whiteco set forth a six-factor test for determining the proper classification of an asset:
- Is the property capable of being moved, and has it in fact been moved?
- Is the property de s igned or constructed to remain permanently in place?
- Do circumstances tend to show the expected or intended length of affixation— that is, do circumstances show that the property may or will have to be moved?
- How substantial a job is removal of the property and how time consuming is it? Is it readily removable?
- How much damage will the property sustain upon its removal?
- What is the manner of affixation of the property to the land?
In contrast, L. L. Bean,8 a case contemporary with Hospital Corporation, demonstrates what will not work. In this case, the taxpayer attempted to classify an inventory storage facility and its related “racking and picking” system as tangible personal property. The court held the facilities to have included structural components that were either inherently permanent or fully integrated, resulting in real property classification.
Splintering an Asset
Under Regs. Sec. 1.1031(a)-1(b), essentially any real estate is considered to be like any other real estate. Typically, a taxpayer will recognize no gain, regardless of the amount of gain actually realized, unless the taxpayer receives net boot (including mortgage exchanges). This generous treatment has caused taxpayers to go out of their way to structure dispositions of real estate as exchanges.
Cost segregation results in splintering a single real estate asset into multiple assets, most of which are not real estate. What would have been the exchange of one building for another becomes the exchange of bundles of assets, a “multi-asset exchange.” The regulations are complex.9 The exhibit presents an example of cost segregation and a later exchange of the building for another building. The effects of the cost segregation increased the taxpayer’s taxable gain on the exchange. The example is based, with modifications, on a situation recently encountered by one of the authors. In reality the properties involved in the exchange were mortgaged. The mortgages have been omitted from the example because they complicate the calculations without affecting the result. Likewise, the example does not reflect bonus depreciation, Sec. 179 expensing, or other more accelerated methods, which generally would tend to further magnify the tax impact of cost segregation on a likekind exchange.
In the example, the client had a cost segregation study performed and elected to change the classification of a significant portion of the assets associated with the building. The Sec. 481 adjustment allowed in the year of change exceeds $220,000. The adjustment results in an immediate tax saving in the year of change, the value of which depends upon the client’s overall tax situation; in the highest bracket, the saving could be over $77,000.
When a like-kind exchange is made two years later, the result is the recognition of $300,000 of gain, all of which is ordinary income under Sec. 1245 (depreciation recapture). Again, the impact depends upon the overall tax situation, but at the highest rate, the additional tax cost would be $105,000. Had the cost segregation election not been made, no gain would have been recognized because the two pieces of real property would have been considered fully like kind. Thus, on the exchange, the client pays a significant amount of tax that it could have avoided.
In this example, the income recognized on the exchange is more than the accelerated deductions from the cost segregation, a result that is clearly disadvantageous for the client. Had the exchange gain been less than the accelerated depreciation, there would have been a small tax advantage due to the time value of money. However, this advantage would likely be more than offset by the costs of the cost segregation study and election.
Another issue a practitioner should examine when contemplating cost segregation is state and local laws regarding the assessment of property tax on real and personal property. The componentization of a building could trigger a reclassification of property into a higher tax assessment class. In addition, the CPA may want to research state and local law regarding sales and transfer tax assessments on personal property versus real property.
A Potentially Unfortunate Result
Cost segregation has become a popular tax saving strategy. While it is a legitimate and often beneficial strategy, it has its drawbacks. One is that reclassifying assets may complicate subsequent like-kind exchanges of the segregated property, often resulting in recognition of substantial gain that the taxpayer otherwise could have deferred. This result can be especially unfortunate because the client may not have received any liquid assets in the exchange yet may still be faced with a sizable tax bill.
When a client is contemplating a cost segregation election, practitioners should incorporate the possibility of a future exchange of the property into the analysis. Failure to do so can result in a costly outcome in terms of tax liability and cashflows.
B. Sue Wood is the principal shareholder of B. Sue Wood & Associates PC, Fort Collins, CO. Donald Samelson is associate professor and director of graduate studies in the Department of Accounting at Colorado State University in Fort Collins, CO. For more about this article, please contact Dr. Samelson at Don.Samelson@ business.colostate.edu.
1 Hospital Corp. of Am., 109 T.C. 21 (1997), acq. in part and nonacq. in part, 1999-2 C.B. 16.
2 For more on personal property included in a like-kind exchange of otherwise real property, see Briskin, “Like-Kind Exchanges: Common Problems and Solutions,” 36 The Tax Adviser 204 (April 2005).
3 See www.census.gov/epcd/naics07/.
4 T.D. 9314. See News Notes, 38 The Tax Adviser 253 (May 2007), and Stevens, “Depreciate Property in Like-Kind Exchanges Consistently,” 206 Journal of Accountancy 74 (November 2008).
5 See IRS Cost Segregation Audit Techniques Guide, and IRS Letter Ruling 7941002 (6/25/79).
6 Rev. Proc. 2008-52, 2008-36 I.R.B. 587, §6.01.
7 Whiteco Indus. Inc., 65 T.C. 664 (1975), acq. 1980-2 C.B. 2.
8 L. L. Bean, Inc., T.C. Memo. 1997-175, aff’d, 145 F.3d 53 (1st Cir. 1998).
9 Regs. Sec. 1.1031(j)-1.