Side effects of cost segregation

Tax advisers need to tally the pros and cons.

By Larry Maples, CPA, DBA and Robert D. Hayes, CPA, Ph.D.
April 2012
Cost segregation

Increased current cash flows and net-present-value savings from accelerated tax depreciation resulting from cost-segregation studies have been discussed in the JofA and other professional literature. But the initial cost-segregation decision can determine later tax side effects, both positive and negative. This article explores some of the tax benefits and drawbacks linked to the use of cost segregation that can materialize in subsequent periods.

Before 1981, taxpayers could break real estate into components, which allowed part of the cost to qualify for the investment credit. The identified personal property also qualified for a much shorter life for depreciation. The Economic Recovery Tax Act of 1981, P.L. 97-34, repealed component depreciation, but the accompanying 15-year life for buildings only temporarily removed some of the sting, because the modified accelerated cost recovery system provisions of the Tax Reform Act of 1986, P.L. 99-514, increased the cost-recovery period to 27.5 years for residential and 39 years for nonresidential buildings.

Taxpayers, however, found refuge in the definition of personal property left over from the repealed investment credit. In the watershed case of Hospital Corp. of America (109 T.C. 21 (1997)), the Tax Court relied on the Sec. 38 definition of personal property, which allowed the taxpayer to use a cost technique that resulted in the classification of many parts of its hospitals as personal property. The IRS eventually agreed that cost segregation does not constitute component depreciation. Current IRS revenue procedures and audit manuals outline what is required to produce a cost-segregation report that passes IRS scrutiny. Click here for the full article.

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