Successful tax planning increases your tax deductions in order to achieve the lowest tax liability possible. Successful tax planning can also allow you to claim those deductions earlier. In fact, through a technique called a cost segregation study, your small business may possibly speed up one of its most common tax deductions: depreciation.
A cost segregation study may allow you to speed up your deduction for the depreciation of certain property by taking advantage of a quirk in the IRS’s depreciation rules. Under Generally Accepted Accounting Principles (GAAP), you usually depreciate all of your business’s property according to your chosen method and over the course of their estimated useful lives. According to the tax law, however, you must depreciate your property according to the IRS’s pre-established charts. These charts mandate a specific depreciation type and period for certain types of assets. They distinguish depreciation treatment for real property (such as land, improvements to land, or fixtures) from that of personal property (such as furniture or movable equipment).
In general, the IRS requires you to deduct non-residential real property using the straight-line method and over a 39-year period. Meanwhile, you may generally depreciate tangible personal property over seven, five, or even three years with the option of using an accelerated depreciation method such as the double-declining balance method. As an example, if you were to purchase two assets of equal price, both land and movable equipment, the IRS would limit your depreciation deduction to much smaller amounts for the land over a long period. Meanwhile, you could claim much higher deductions over a shorter period of time for the equipment. As a result, it greatly behooves your company to maximize your treatment of assets as tangible personal property and to only treat assets as real property when necessary.
Engaging in the Study
To ensure that you are taking your depreciation deductions as quickly as possible, you could employ a cost segregation study. This process involves hiring a qualified professional to examine your real property and to ensure that all its components are correctly classified. This study may occur during construction of, after you acquire, or even while you are currently using your real property.
A qualified professional should possess knowledge of the construction process, engineering, and tax law in order to conduct the study. After its conclusion, the professional should provide a cost segregation report to support his/her findings. Highlights of the report should include:
An explanation of the method used to classify assets and their associated costs. An explanation of the expert’s legal analysis. An organization of the assets. A reconciliation of the total allocated costs to total actual costs. An explanation of how indirect costs are treated.
Adjusting the Deduction
If a cost segregation study suggests that you could treat certain assets as tangible personal property instead of real property, you should alter your depreciation method to obtain an accelerated tax deduction. To properly do this, you have to file a Form 3115, Application for Change in Accounting Method, with the IRS. You can even ask for the agency’s automatic consent to the change. However, you should not file any amended returns for past tax years to adjust for the increased depreciation amounts in those years. Unlike GAAP, where you can reissue financial statements for past fiscal years under a new method of accounting, the IRS will generally disallow a retroactive change in your method of accounting, but only for special rare circumstances.
Precautions to Take
Finally, while a cost segregation study has great potential to assist in your tax planning, there are some issues to keep in mind. Many conflicting judicial decisions have arisen when taxpayers may treat certain items as tangible personal property. As a result, there are no bright-line rules for determining when property is properly treated as tangible personal property versus real property. This means that any IRS audit would likely involve a very facts-intensive analysis on a case-by-case business. In light of this, substantiating your decision through a high quality cost segregation report becomes very important.
Further, you cannot accelerate the depreciation deduction for tangible personal property that was purchased along with real property and whose cost was included in the overall price. In these special situations, the U.S. Tax Court has ruled that you must depreciate the personal property in the same manner as the real property to which it is bundled; even despite their usual classification. This ruling is noteworthy in planning a successful cost segregation study.