Cost Segregation Study

A cost segregation study is perhaps the newest service in the real estate investor's tax arsenal. Recent legislation has clarified both the process and what property qualifies for a cost segregation study, giving taxpayers the guidance they need to rely on when filing their tax returns.

A cost segregation study allows investors who own residential or commercial investment property to increase the profitability of their investment by accelerating their depreciation deductions for personal property that is improperly classified as IRC § 1250 real property. When purchasing or improving real estate used for business or investment purposes, real estate investors must depreciate these properties over 27.5 years for residential rental property and 39 years for non-residential property. However, not all of the property acquired or improved is necessarily real property. Accordingly, instead of depreciating all of the property over one of the aforementioned longer periods, the taxpayer may reclassify certain portions as IRC § 1245 personal property with a shorter life span.

A cost segregation study is available for property or improvements placed in service after 1986. However, it was not until 1997, with the decision in Hospital Corp. of America v. Commissioner of Internal Revenue, 109 T.C. 21 (July 24, 1997), that something akin to component depreciation was allowed under the Modified Accelerated Cost Recovery System (MACRS) that was introduced by the Tax Reform Act of 1986.

In Hospital Corp. of America (HCA), the Tax Court ruled that items in a building that qualify as tangible personal property under the former investment tax credit rules, as defined in Treas. Reg. § 1.48-1(c), may be depreciated under MACRS more rapidly as personal property. If a building component is not personal reclassifying these 27.5- or 39- year properties as personal property with a five, seven or 15 year depreciable life.

It is important to note that the Tax Reform Act of 1986 provides that the applicable period of recovery for improvements begins on the later of the date on which the addition or improvement is placed in service, or the date on which the property with respect to which the addition or improvement is made is placed in service.

Thus it is not necessarily the date upon which real property is acquired, or improvements to real property are completed, which governs the start of the property's depreciable life, but the date that the property or improvements are put into service. Furthermore, the depreciable life for improvements to real property is to be computed in the same manner as the underlying property if such property was placed in service at the same time as such improvements. Thus, the nature of the underlying property may control whether it is residential or non-residential.

Prior to the Tax Reform Act of 1986, lessees could depreciate improvements to real property over the artificial period of the lease term. In many cases the lease term bore little or no resemblance to the actual depreciable life of the improvements. Since the Act, leasehold improvements are subject to the same depreciation deduction rules that would apply for regular improvements to real property. However, in the case of leasehold improvements the lessee will recognize gain or loss, if any, at the time the lease terminates. 26 U.S.C.A. § 168(i)(8). Once the lease terminates, a lessor must deduct the unrecovered adjusted basis of leasehold improvements that are abandoned or destroyed due to the termination of the lease agreement, if such abandonment or destruction occurred after June 12, 1996.