Construction companies seeking a competitive edge should become familiar with the mechanics of cost segregation studies and the significant tax benefits they offer. Not only can you use the study to reduce your own tax bill, but consulting on your company’s studies can create a new source of revenue.
A cost segregation study applies engineering and tax accounting principles to identify building components and construction costs that qualify for accelerated depreciation deductions. Commercial real property generally is depreciable over 39 years, while residential real estate is depreciable over 27½ years. But in many cases, a portion of the cost of real property is properly allocated to shorter-lived assets depreciable over five, seven or 15 years.
Such assets might include:
- Furniture and equipment,
- Electrical connections and wiring,
- Plumbing or foundations for specialized equipment or machinery,
- Paving and sidewalks, landscaping, and fences,
- Telephone systems, and
- Removable partitions, walls, and floor coverings, among other items.
Let’s look at an example that illustrates the tax-saving potential of a cost segregation study.
A contractor acquired a new building for $10 million to house its offices, equipment storage and other facilities and moved into the building in January 2015. If the contractor were to depreciate the entire cost on a straight-line basis over 39 years, it would deduct roughly $250,000 per year.
The company conducts a cost segregation study, which concludes that $2 million of the purchase price is allocable to assets that are entitled to accelerated depreciation over five years. The result? The contractor increases its first-year depreciation deductions by about $650,000. Assuming that its combined federal and state income tax rate is 40%, and that it has sufficient income against which to offset its increased depreciation deductions, the company reduces its 2015 tax bill by about $260,000.
Consulting with clients
Typically, CPAs oversee cost segregation studies, but construction companies are uniquely suited to provide consulting services to their clients in connection with these studies. The best time for a study is during a project’s planning phase, because the information needed to support cost classifications is most readily available. And the contractor is ideally positioned to isolate and document qualifying costs as they’re incurred.
Even existing buildings are viable candidates for a cost segregation study. And if cost information is unavailable, a construction company can support a study by estimating the costs associated with various assets using standard estimation techniques.
Cost segregation studies also can be used to ensure compliance with the “repair regulations,” which, among other things, distinguish between improvements, which must be capitalized, and repairs, which are currently deductible. The regulations also require building owners to recognize a loss on the removal or other disposition of certain structural components. Contractors can help their clients distinguish between repairs and improvements, segregate the costs of structural components disposed of in prior years and review the results of previous cost segregation studies for compliance with the repair regulations.
Worth a look
Contractors looking for new revenue sources should consider offering cost segregation consulting services. These services can help your clients realize significant tax savings while setting your company apart from the competition.