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Tax & AccountingOctober 13, 2021

2021 Tax Planning: Tax Benefits of Cost Segregation

By: CCH AnswerConnect Editorial

Taxpayers can expedite depreciation deductions through cost segregation of certain building components.

Business and individual taxpayers that acquire nonresidential real property or residential rental property have an opportunity to reduce the depreciable lives on assets which are building components. Certain assets may qualify for shorter lives and recovery periods under MACRS depreciation. The reduction of the asset lives provides accelerated deductions to offset income.

Planning Opportunities

Many taxpayers mistakenly include the cost of such components in the depreciable basis of the building and the cost is recovered over a longer depreciation period. The characterization of property as personal under local law does not control its characterization as personal property for depreciation and investment credit purposes. Non-residential real property is depreciated over a 39-year life and a residential rental property is depreciated over 27.5-years. Certain building components may qualify for a reduced recovery period over 5-years, 7-years, or 15-years.

Some examples of building components include land improvements or personal property:

  • parking lots, sidewalks, curbs, and roads
  • fences
  • storm sewers
  • landscaping
  • signage
  • lighting
  • security and fire protection systems
  • removable partitions
  • removable carpeting and wall tiling
  • furniture
  • counters
  • appliances and machinery (including machinery foundations) unrelated to the operation and maintenance of the building 
  • the portion of electrical wiring and plumbing properly allocable to machinery and equipment that is unrelated to the operation and maintenance of the building

If a building component is not personal property under the former investment tax credit, then it is considered a structural component of the building and, therefore, is property and depreciated as part of the cost of the building over the building's longer recovery period. However, if a structural component is added to an existing building then it is depreciated separately as an addition or improvement. The later added structural component is depreciated using the same method and period that would apply to the building if the building were placed in service at the same time as the structural component.


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Cost Segregation

A taxpayer may engage a specialist to conduct a cost segregation study to identify the separately depreciable components and their depreciable basis. Ideally, a cost segregation study should be conducted prior to the time that a building is placed into service (i.e., when it is under construction or at the time of purchase). However, a cost segregation study can be completed after a building is placed in service. Even if a detailed cost segregation study is impractical, a practitioner should carefully consider whether there are any obvious land improvements and personal property components of a building that can be separately depreciated over a shorter recovery life.

Review the building components below that can be depreciated through cost segregation

Structural Components

The term "structural component" includes such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings, therefore, such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building.

Generally, real property only includes a structure that is a building and is property. A building is specifically excluded from the definition of a land improvement for purposes of MACRS. Under these tests, a structure is not a building unless it is designed to be permanently attached to the ground and also meets an appearance and function test. Generally, a structure that is not a building will either be a land improvement (if it is "inherently permanent") or personal property, which is usually depreciable over a shorter period than a land improvement. The courts have developed two tests derived from the investment tax credit regulations to determine whether a structure is a building: (1) the inherent permanency test and (2) the appearance and function test.

Land Improvements

Land improvements will generally be categorized as property. Land improvements include, for example, swimming pools, paved parking areas, sidewalks, roads, bridges, and fences because these structures are inherently permanent and are not buildings.

Tangible Personal Property

Tangible personal property includes (but is not limited to) all property, other than structural components, which is contained in or attached to a building. All property that is in the nature of machinery (other than structural components of a building or other inherently permanent structure) is considered tangible personal property even though located outside a building. Examples include:

  • production machinery
  • printing presses
  • transportation and office equipment
  • refrigerators
  • counters
  • testing equipment
  • display racks and shelves
  • neon and other signs contained in or attached to a building

Filing requirements for depreciation recovery period changes. The change to the depreciation lives requires either an amended return (if only one return has been filed) or an accounting method change (if two years after the property is acquired or placed in service). The reporting to the IRS includes the change of basis, depreciable lives, and any adjustments for the impact of the depreciation acceleration from the date placed in service to the year of the method change.

The accounting method change is used because the taxpayer is seeking permission to correct the recovery period of assets that were misclassified as real property. The unclaimed depreciation may be claimed as an adjustment deduction in a single tax year. The taxpayer must file Form 3115, Application for Change in Accounting Method.

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CCH AnswerConnect Editorial

Comprising of industry’s most trusted experts, the Wolters Kluwer CCH AnswerConnect Editorial Staff are knowledgeable and highly qualified to analyze and offer guidance on the latest, important tax topics. They ensure every topic is thoroughly researched and meticulously broken down so you receive the most up to date and accurate information available. Read more of their insights on CCH AnswerConnect.

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