Cost segregation studies have increased in popularity with middle market companies and small business owners who own real estate. We explore the potential benefits and risks of this tax planning tool.
What is a cost segregation study?
Cost segregation (“cost seg”) studies are analyses of building costs for the purpose of identifying and quantifying business property eligible for accelerated depreciation for tax reporting purposes. They are essentially a tax savings and cash flow planning tool, typically utilized by businesses that acquire or construct commercial buildings and other real estate property.
Although these studies have existed for more than three decades, the passage of recent tax legislation has helped to further enhance the benefits associated with them. As a result, there has been an industry-wide surge in their popularity, especially as smaller businesses, owners of rental properties and their tax advisors become increasingly savvy about the power of this tax planning tool.
A closer look at related tax legislation
Tax legislation passed within recent has included several provisions that have been particularly beneficial to taxpayers who invest in commercial real estate and rental properties. For example, the Protecting Americans from Tax Hikes (PATH) Act of 2015 created a new category of property, Qualified Improvement Property or “QIP,” to apply bonus depreciation eligibility to a category of property that is especially meaningful to small business owners, tenants and landlords.
Shortly thereafter, the Tax Cuts and Jobs Act (TCJA) of 2017 increased first-year bonus depreciation to 100%, but inadvertently included a technical error that made QIP ineligible for bonus depreciation. In 2020, Congress passed the Coronavirus Aid, Relief and Economic Security (CARES) Act, correcting the error and making QIP eligible for 100% bonus depreciation.
Taxpayers are also realizing that cost segregation can be utilized in tandem with other tax planning strategies. For example, these studies can be completed on property acquired as part of a Sec. 1031 like-kind exchange. There are also synergies between cost seg studies and Historic Rehabilitation Tax Credits analyses that can translate into meaningful efficiencies. For newly constructed properties, taxpayers are increasingly looking to enhance the benefits of cost seg studies by simultaneously including work to secure the Sec. 179D tax deduction related to energy-efficient commercial buildings.
Service provider landscape is changing
With the booming demand for cost segregation and related tax offerings, the landscape of service providers focused on these areas is no longer dominated by the Big Four public accounting firms or even the top 100 U.S. firms. The depth of experience in this field is rapidly expanding, and many providers are adopting their own approach and interpretation aligned with their appetite for audit risk.
Evolving regulatory landscape
The IRS has taken notice of the increasing popularity of cost seg studies and is beginning to issue more guardrails around their use. It initially issued its first Audit Techniques Guide (ATG) for cost segregation almost 20 years ago in response to the increased application of these studies and to also acknowledge the seminal Healthcare Corporation of America (HCA) v. (IRS) Commissioner case. At the time, the published ATG represented a formal acknowledgment of the legitimacy of cost seg while simultaneously laying the groundwork for future rules for the studies.
In its most recent 2022 update, in response to the expansion and changes in this practice area, the IRS put taxpayers on notice that they should expect added scrutiny when it comes to cost segregation studies. Additionally, the IRS has established a “more likely than not” standard as it applies to tax positions relied upon in these studies – suggesting that consultants issuing these studies and CPAs signing off on the tax positions may be subject to “preparer” penalties if their work does not measure up.
Cost seg continues to grow in popularity as a tax planning strategy for companies, small business owners and investors who own real estate of all types and sizes. However, taxpayers and their CPAs should expect increased scrutiny from the IRS around them as the regulatory landscape evolves. BPM’s team of professionals can advise on the use of cost segregation studies and get help mitigating future risks as new rules related to this planning tool are released in the future by the IRS.