FEATURE ARTICLE, APRIL 2004

Using Cost Segregation for Tax Savings
Owners of commercial real estate can save taxes by reclassifying real estate assets as personal property.
Mark Koetting

Individuals who own commercial buildings can potentially save money by implementing a tax-saving strategy called cost segregation. Simply put, cost segregation is a way of lowering taxes by reclassifying real estate assets as personal property.

Fixtures in, on or around a building have generally been considered real property and, as such, depreciate during a period of 39 years. However, some fixtures can be treated as being separate from the building itself and, therefore, can be reclassified as personal property, which depreciates in a much shorter period of time.

Knowing which assets can be segregated and which cannot is tricky, but the tax implications are substantial. For example, a warehouse purchased for $1 million typically has $100,000 to $200,000 worth of property in the building that can be segregated as personal property. It would not be unusual for a restaurant building purchased for $1 million to contain $300,000 or more in personal property.

Is This Structure a Building?

For tax purposes, an important first step in assessing the tax liabilities of a building is to determine if, indeed, it really is a building. Not all structures are buildings. For example, the Empire State Building is a structure and a building. However, a mobile home is only a structure. It is important to make this determination because the depreciation periods vary between the two.

According to the Internal Revenue Service (IRS), a building generally refers to “any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is … to provide shelter or housing, or to provide working, office, parking, display or sales space.” Structures that are not buildings have a shorter depreciation period than structures that are buildings.

In determining whether or not a structure is a building, the courts have developed two tests, which assess a structure’s permanency and function. While various factors come into play in assessing any individual structure, the two tests are fairly straightforward.

The Permanency Test: Courts have ruled that a structure cannot be a building unless the structure is “inherently permanent.” Some structures are easy to classify, while others are not so clear-cut. Few would question the permanency of a high-rise office building, but what about a self-storage unit? In general the bigger the structure, the more likely it is to be classified as permanent. The Tax Court has enumerated six criteria for determining a structure’s permanency:

• Can the building be moved?

• Is the property designed to stay in place permanently?

• How long is the structure intended to stay in place?

• Is the structure easy to remove?

• How much will the property be damaged by removal?

• How is the property affixed to the land?

The Function Test: According to an old proverb, if a bird swims like a duck, quacks like a duck and waddles like a duck, then it probably is a duck. Simplistic as it may seem, the same can be applied to buildings. If a structure looks like a building and functions like a building, for tax purposes, it is generally classified as a building. As with the Permanency Test, a wide range of factors comes into play in deciding whether or not, based on its function, a structure is a building. Courts look closely to see if the structure in question is used substantially as workspace for employees. The more employees that use the structure as a workspace, the more likely it is to be classified as a building.

When a structure is determined to be a building, the taxpayer can look to improve his or her tax position through cost segregation, reclassifying assets located within the structure as personal property.

Although there are no rules that govern how much or what percentage of property within a building can be reclassified as personal property, the following guidelines have been established:

• Retail Stores: 5 percent to 25 percent

• Apartments: 10 percent to 20 percent

• Warehouses: 10 percent to 20 percent

• Office Buildings: 10 percent to 20 percent

• Hotels: 20 percent to 30 percent

• Grocery Stores: 20 percent to 30 percent

• Manufacturing Facilities: 20 percent to 60 percent

• Restaurants: 25 percent to 35 percent

It is important to note that these are general guidelines. The costs that can be segregated are determined by the specific assets within a building. It is entirely possible for the segregated costs within a warehouse, for example, to exceed 20 percent. Each asset must be examined, and a critical question must be asked: Is this a component part of the building or a separate asset?

Component Part Versus Separate Asset

According to the general principles of property law, anything that is attached to a building or the land it sits on is part of the building. But these principles do not 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 does not necessarily mean it cannot be reclassified as personal property. The central question is: Is the asset necessary for the maintenance and operation of the building, or strictly for the operation of the business that is conducted within the building?

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

Even items that are attached to the building can be classified as personal property if they are relevant to the business and not requisite to the operation and maintenance of the building. Shelves, wall safes and servers in an office building may be attached, but they are clearly part of the business and not important to the building itself. Similarly, booths in a restaurant and shelving in a warehouse, though attached, can be classified as personal property. Logic dictates the classification of assets in many cases.

Still, some items are ambiguous and subject to interpretation. For instance, carpeting has been viewed as both part of the building (because it is part of the flooring, a building necessity) and part of the business (because carpeting is not always permanently attached). Even the IRS has ruled that carpeting can go either way. The precedent has been established that if carpeting is glued down using a permanent adhesive, it is considered to be part of the building. If it is merely tacked along the edges, it can be classified as personal property. Similarly, the precedent for classifying other items commonly found within buildings has been set during the years through court cases and rulings.

When to Hire a Specialist

While it is not specifically required by the IRS, getting the opinion of a cost segregation expert is advisable. Often, an accountant is adequate to perform a cost segregation study. Cost segregation specialists, who have expertise in building structure and components, are available to perform studies in cases where an accountant or attorney is not sufficient. Typically, it is not cost-effective to hire an expert unless the cost of the building exceeds $500,000.

A good cost segregation specialist will determine if a full-blown study is warranted, based on a rough calculation of the personal assets versus the structural property. In some cases, the cost of the study may outweigh the potential benefits. If a study is deemed to be feasible, the specialist will conduct the study and issue a report based on a thorough examination of the building and its contents, a study of the blueprints and a consultation with architects. Reporting requirements are stringent. A thorough report is often a lengthy document and can include photographs and other supporting evidence.

The best time to do a cost segregation study is when a building is purchased or before the end of the tax year. This tends to optimize tax savings and clear up any confusion that may arise. It is possible for the taxpayer to take advantage of cost segregation later, but problems may be encountered. These problems may or may not impact the feasibility of a cost segregation study.

While the process of cost segregation may seem daunting, in many cases it results in substantial tax savings. Since segregating costs of personal property from real property can decrease a building owner’s tax liability, making this effort is often highly beneficial.

Mark Koetting is vice president of Lenexa, Kansas-based Cost Seg Consulting.

©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.