Cost Segregation Studies for Commercial Properties

Commercial property inspectors, as well as investors who have recently acquired or are building a commercial property, should know about the advantages of having a cost segregation study (or CSS) performed for their own businesses and for others.  This IRS-sanctioned program, based on the Investment Tax Credit, could mean a savings of more than 20% on taxes for the depreciation of the non-permanent, non-structural assets of their commercial investments.  Commercial property inspectors may also want to investigate ways they can offer their inspection services for a CSS, although this lies outside of InterNACHI’s Standards of Practice for inspecting commercial properties.

The term “cost segregation” (also known as cost allocation) comes from the need to make the distinction, for income tax purposes, between real property and personal property, which together constitute a commercial property.  The different non-permanent components and systems that make up personal property depreciate at a faster rate than real property (as allowed by the IRS), so having a CSS performed makes sense because it generally means a lower tax liability – and more available cash flow – for property/business owners.  Currently, the rate of depreciation for real commercial property is 39 years, and for a residential rental property, the rate is 27½ years (the same length of time as for a home).  The purpose of a CSS, then, is to separate the personal property assets from the real property assets and identify and properly classify the non-structural systems and components of a commercial property so that, under IRS guidelines, the depreciation of certain qualifying assets can be accelerated to five, seven or 15 years instead of 27½ or 39 years.

Conventional wisdom suggests that a cost segregation study should be performed for commercial properties valued at $200,000 or more, including new construction, remodeling /expanding an existing building, turnkey properties and those being re-purposed.  Eligible commercial businesses run the gamut and include restaurants (both eat-in and fast-food), retail and chain stores, grocery stores, shopping malls, office buildings, gas stations, auto sales lots, hospitals and healthcare facilities, factories and manufacturing plants, and even theme parks and sports stadiums and arenas – and the list goes on.  Of course, also included in the category of commercial properties are hotels, motels and rental apartment complexes.  

With a CSS, all non-permanent, non-structural components – those that suffer from regular wear and tear and need replacement every few years – will depreciate tax-wise at a rate that is reasonable for the business owner, compared to the permanent structural elements of the property.  Eligible items include not only various capital assets such as office equipment, furniture, fixtures, carpeting, window treatments, security systems, and various interior elements, but also major systems that are specialized as they relate to the commercial property's specific operation, which can include the electrical, plumbing and HVAC.  Additionally, exterior improvements and upgrades are also eligible for accelerated depreciation, such as landscaping, walkways and parking lots, etc.

Structural and building engineers who are trained to read blueprints, and those with a background in construction, are well-suited for some of the demands of properly performing a CSS – specifically, the inspection and inventory aspects in terms of asset classification and costs.  Commercial property inspectors are arguably qualified to perform such inspections as well, especially if they have additional aptitudes for understanding financial records, accounts payables, construction permits, change orders, etc.  The key to performing a CSS that can withstand the scrutiny of the IRS is adequately understanding accounting principles and staying up to date with property tax law so that owners can pay the appropriate amount of tax while taking advantage of available depreciation allowances. 

One practical approach that commercial property inspectors can take to exploit this niche market may be to offer their inspection services directly to engineering firms, commercial property insurers, Realtors, CPAs and tax preparers, and others who offer comprehensive CSS services to their commercial clients.  Despite the burgeoning cottage industry of specialized firms that offer CSS services, there are no singular industry standards that dictate how to conduct or report a CSS in this still-evolving area of federal tax law.  The IRS continues to develop its own guidelines for understanding and auditing returns that claim depreciation under these rules that favor the commercial property owner.  Especially because “catch-up” depreciation is available to property owners who purchased commercial property after 1987, it appears that Uncle Sam, in this case, is on the side of the taxpayer.