Help owners build cash flow with cost segregation studies

By Randy Bonnecaze

Commercial real estate owners are constantly seeking opportunities to increase cash flow from buildings they either use in their own businesses or lease to other parties. And cash flow from a real estate development often determines whether its owner will add new structures to the property or improve existing facilities. In other words, your construction company's livelihood depends on profitable properties.

Background and objectives

For federal income tax purposes, the IRS generally requires owners to depreciate real nonresidential property using a 39-year, straight-line method. But they can depreciate other types of related assets much more quickly. For example, owners must usually depreciate most equipment and furnishings over five to seven years. And owners typically have to depreciate land improvements associated with real property over 15 years. Now think of the savings if an owner could reclassify some previously considered 39-year components as a shorter class-life property. That's exactly what a cost segregation study enables owners to do.

Contributors and information

To arrange and conduct a cost segregation study, you and an owner will need to engage a qualified financial professional. He or she can perform this service for newly constructed or purchased facilities as well as remodeled or rehabilitated structures. The financial professional will typically need information such as:

• A full set of construction plans,


• A final AIA application and certification for payment,


• Building-cost budgets,


• Changeorders, and


• Any undocumented direct or indirect costs.

In addition, a construction specialist (that's you), engineer and architect will need to inspect the site. They will measure and estimate costs using current accepted techniques and pricing guides to determine which items will qualify for shorter depreciation periods.

Recent developments

The issue of what qualifies for accelerated depreciation has, not surprisingly, stirred up some controversy over the years. A 1997 tax court case and a 1999 IRS comment support the rule that items qualifying for accelerated depreciation must not be structural building components.

According to IRS criteria, a structural building component is one that would damage the building if it were removed. Conversely, if one could easily remove the component without damaging the structure, it generally will qualify for a shorter depreciable life. The most common construction costs that owners can reclassify usually involve electrical and plumbing elements. For example, specialty wiring for machinery necessary to operate specific, tangible personal property typically qualifies for a shorter depreciable life.

Another recent development clarifies whether owners may reclassify purchase, construction or remodeling costs in a later year.

The short answer is yes, they may do so. But the IRS considers this a change in the method of calculating depreciation, and therefore an accounting method change. Typically, accounting method changes require the permission of the commissioner of the IRS.

But the agency now offers an automatic consent procedure for changing accounting methods in this instance. It accounts for a depreciation method change by calculating an owner's taxable income ratably over a four-year period, beginning with the year of change.

Advantageous results

Having read all this about cost segregation studies, you may be asking, "So what's in it for me?" Plenty. Understanding this process and using its techniques independently can allow you to obtain a competitive advantage when bidding. And by getting a cost segregation professional involved early in a project, you'll lessen your data-collection burden.

Editor's Note: Randy J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis T. Bourgeois LLP, Baton Rouge.