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According to U.S. tax laws and accepted accounting practices, cost segregation consists of identifying personal property assets and separating them from real property assets in an accounting system to minimize taxation. The purpose of a cost segregation study may be to shorten depreciation time on personal property assets in order to reduce current income tax liabilities or to lengthen depreciation time if deferral of tax savings into future years is more advantageous. Personal property assets include the non-structural elements of a building, exterior land improvements and some indirect construction costs.
When the U.S. Congress enacted the Tax Reform Act of 1986, it introduced an accounting concept known as the modified accelerated cost recovery system that eliminated component depreciation but allowed cost segregation. In a 1997 legal case, Hospital Corporation of America v. Commissioner, the U.S. Tax Court permitted the use of cost segregation in relation to a multitude of property improvements and a clear distinction was made between items categorized under Internal Revenue Code Section 1250 for real property and items categorized under Section 1245 for tangible personal property. But because some legal controversy over definitions still exists and it is not necessarily easy to correctly distinguish between real property and tangible personal property, a cost segregation study performed by an independent expert is essential.
The advantages of cost segregation include write-offs for building components that need to be replaced, front loaded depreciation deductions and lower local realty transfer taxes.
adjusting the timing of deductions to maximize tax savings because when an asset’s life is shortened for accounting purposes, the depreciation expense is accelerated and tax payments are initially decreased applying tax savings retroactively because taxpayers can capture immediate retroactive savings on property added since 1987 identifying additional opportunities to reduce real estate tax liabilities and certain sales and use taxes creating an audit trail to minimize unfavorable audit adjustments
Cost segregation studies most often identify building costs that would normally be depreciated over a 27.5 or 39-year time period and reclassify them to allow an accelerated method of depreciation. Costs for non-structural elements such as lighting, carpeting, wall coverings, sidewalks and landscaping can be depreciated over 5, 7 or 15 years. Some segregated assets may also qualify for a special 30% bonus depreciation that was allowed by the Job Creation and Worker Assistance Act of 2002 or a 50% bonus depreciation that was allowed by the Jobs and Growth Tax Relief Reconciliation Act of 2003.
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