Depreciation and Cost Segregation

A capital asset is a piece of equipment, a building, or a vehicle for use in your business. These assets naturally wear out, lose value, or become obsolete. Because they must ultimately be replaced, and because investment in improvements is allowed to be recovered before income produced from improvements is taxed, a deduction for depreciation is allowed prior to the the determination of taxable income. Fortunately, the current tax system has provided for depreciation allowances in excess of the actual economic decline of the property. This is to the benefit of the investor.

The cost of these "capital assets" should be written off over the same period of time you expect them to earn income for you. Therefore, you must spread the cost over several tax years and deduct part of it each year as a business expense.

What Can Be Depreciated?

Many different kinds of property are depreciable - for example: machinery, buildings, vehicles, patents, copyrights, furniture and equipment. You can depreciate property if it meets all the following requirements:

• It must be used in business or held to produce income
• It must be expected to last more than one year
• It must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes

How much can be Depreciated?

Depreciable Basis is generally equal to the cost of the improvements. This includes the acquisition costs plus any installation costs of putting it into service. Also included are any capital improvements made during the ownership period.

What Cannot Be Depreciated?

• Property placed in service and disposed of in the same year
• Inventory
• Land
• Repairs and replacements that do not increase the value of your property, make it more useful, or lengthen its useful life

Many investors make the mistake of simply taking the value of their investment property, assuming (for example) 15% is land value, and depreciating the rest at the going rate (27.5 or 39 years). You can be much smarter about it by using cost segregation.

Cost Segregation

Residential real estate has to be depreciated over 27.5 years and non-residential real estate over 39 years. However, not everything put into a rental is real property. Many items qualify as tangible personal property and have a much shorter life span, for depreciation purposes. This means you obtain a much greater depreciation benefit over a shorter period. Examples of 5-year property include appliances, carpets, and furniture. 15-year property includes land improvements such as sidewalks, roads, bridges, fences, landscaping, and shrubbery.

While this is easiest to measure when building a new building or remodeling an existing building, it is possible to separate the various pieces in purchasing an existing building. If you’re purchasing an existing property, make sure the sales contract spells out what the purchase price includes with values for the items that can be depreciated faster.

Failing that, and for a large enough purchase, it is still possible to have an engineer break out the various parts of the purchase. You would want to review any purchase or remodeling job with your tax adviser to properly allocate the costs to items that can be depreciated more quickly than the structure can. Once the shorter-life property is identified and reclassified, the depreciation that could have been claimed in the preceding tax years can be deducted now.

Cost segregation should be considered for all buildings and significant tenant improvements placed in service after 1986. The changes noted below make cost segregation even more attractive and necessary in many cases.

Cost segregation studies can reduce the real estate holding costs, increase cash flow, and maximize the investment returns. Recent IRS changes also allow owners to achieve faster recovery of depreciation unclaimed in previous years, which further increases the value of cost segregation. In other words, if you haven’t done it yet, you can still do it and save even more going forward.

Also see: IRS publication 946, "How to depreciate property"