The depreciation of assets can provide important tax benefits. Taxpayers prefer to depreciate assets over a shorter rather than longer period of time as this allows for a larger annual tax deduction. Building and structural components have substantially longer depreciable lives (39 years for non-residential real property and 27.5 years for residential real property) than personal property (which could be 3, 5, or 7 years). Taxpayers use cost segregation studies to identify certain components of real property which may have shorter depreciable lives.
With the enactment of the final Tangible Property Regulations, cost segregation studies have an expanded role in assisting taxpayers with making partial asset disposition elections and deducting removal costs. Cost segregation studies can also create smaller units of property which could be detrimental to the repair versus capitalization analysis under the Tangible Property Regulations. When analyzing whether an expenditure is a betterment, restoration or adaptation under the Tangible Property Regulations (and thus required to be capitalized), the larger the unit of property, the more likely the improvement will not be considered material or affect a significant portion of the unit of property, and thus will be deductible.
Although for the 2015 tax year a taxpayer can no longer take a loss for partial asset dispositions that occurred in prior years, losses are allowed for current year partial asset dispositions. Prior to the issuance of the final regulations for partial asset dispositions, when a component of an asset was removed and subsequently replaced, both assets continued to be depreciated. Now, when the old component is removed, an ordinary loss can be taken in the year of the removal. The loss is the amount of the remaining depreciable basis of the portion of the asset that was disposed of. One method to calculate a partial asset disposition loss is to use a study allocating the cost of the asset to its individual components. However, once a cost segregation study is used to make a partial asset disposition election, the cost segregation study must be used for any future determinations of remaining basis for partial disposition of other portions of the same asset. Thus, the cost segregation study should be detailed to show how the basis determination was made.
When there is a partial asset disposition, there are removal costs associated with that disposition. The final Tangible Property Regulations include favorable provisions regarding the treatment of removal costs. If a taxpayer disposes of an asset, including a partial asset disposition, and takes into account the adjusted basis of the asset or component of the asset in realizing gain or loss from the disposition, the costs to remove that asset can also be deducted. Cost segregation studies can determine the adjusted basis of components removed during a renovation or remodeling. If the renovation or improvements to the asset are required to be capitalized, a partial asset disposition election can be made, allowing for a loss on the disposition and a deduction of the removal costs. Knowing the basis of the components removed will facilitate this tax treatment.
In determining whether the costs associated with a renovation, remodeling or improvement to an asset should be capitalized or deducted as a repair, the unit of property definition is important. The larger the unit of property, the more likely the expenditure would be considered a deductible repair. Generally, the unit of property for a building is the building and its structural components and systems. Cost segregation studies break out the personal property components of that building into separate smaller units of property. If after the cost segregation study is completed there is a renovation or improvement to one of those carved- out assets, there will be a smaller unit of property to consider when making the capitalization or deduction analysis. As such, it is more likely that the cost of that improvement will have to be capitalized. If you are aware of an asset that is going to be subject to an improvement in the future and you want to retain the larger unit of property, one option is not to break out that asset from the building. Additionally, an analysis should be done to see if the overall benefit of the cost segregation study will outweigh the risks that the costs of the improvements made to the components of the asset will be capitalized. Given the large potentially large benefits of taking accelerated depreciation on those assets, more likely than not, it will.
When there is a cost segregation study performed, there will be changes to the way an asset is depreciated. When that occurs, the taxpayer will have to file a Change in Accounting Method Form (Form 3115). This presumes that the asset was not acquired in the year of the change. In that scenario, the asset can just be reported using the shorter class life. The taxpayer will most likely recognize a negative adjustment associated with the change as the purpose of the cost segregation study is to change assets with longer class lives to shorter class lives. A negative adjustment will occur if the taxpayer reported less depreciation each year due to utilizing a longer class life. A negative adjustment is recognized in full in the year of change and could generate a large tax benefit depending on the amount of the adjustment.
The tax consequences associated with cost segregation studies related to the final Tangible Property Regulations are quite complicated. The professionals at Friedman LLP have extensive experience applying the Tangible Property Regulations and can answer any questions you may have.