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Typically owners of residential rental property depreciate the entire cost of their building over 27.5 years. Owners of other types of buildings, such as offices, retail space, grocery stores, restaurants, warehouses, and manufacturing plants often depreciate the entire cost using a 39 or 31.5-year depreciation period, respectively, depending upon the date of acquisition.  Under IRS cost segregation guidelines, however, a significant portion of a building's cost can be depreciated over much shorter periods, usually five or seven years.

The cost segregation rules are complicated, but in brief they allow a taxpayer to separately depreciate components of a building that are unrelated to its "operation and maintenance" over the shortened depreciation periods. In addition, these depreciation deductions are computed using an accelerated depreciation method which allows costs to be recovered at twice the rate that applies under the "straight-line" method. The slower straight-line method is used to depreciate residential rental property and other types of buildings but this may not be the best option for your commercial properties.

A cost segregation feasibility study is normally conducted by an outside consultant who specializes in this area.  These outside consultants have high standards to adhere to in order to provide a study which is acceptable to the IRS.

Many types of building components can qualify for the shortened depreciation period and accelerated depreciation method. Here are some common examples:

✔ Molding

✔ Millwork

✔ Carpeting

✔ Wall coverings

✔ Partitions

✔ Counters

✔ Cabinets

✔ Shelving

In addition, certain land improvements located outside of a building may be depreciated over 15 years. Land improvements include items such as:

✔ Landscaping

✔ Fences

✔ Curbs

✔ Parking lots

✔ Lighting

✔ Utilities

✔ Swimming pools

✔ Tennis courts

✔ Playgrounds

These lists are not all encompassing.  There are many other items that can qualify for the shortened depreciation period. Depending upon the type of building, you can expect to deduct between 10 and 60 percent of its cost over the shorter recovery period. 

In addition to identifying personal property elements, the study will allocate the appropriate costs to these items. Such costs include direct material and labor costs, as well as indirect costs such as architect and engineering fees and impact and permit fees. In the case of an existing building where records are not readily available, valuation experts may rely on standardized cost estimation manuals. However, it may be more expensive to perform a cost-segregation study on old construction because of the increased difficulty in obtaining the pertinent records and documentation.

Set forth is a recent example of a cost segregation analysis prepared for a client.

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