When Cost Segregation Costs Extra

Why cost segregation for a property may not be beneficial where the taxpayer later exchanges the property in a like-kind exchange.

August 2009
by B. Sue Wood and Donald Samelson/The Tax Adviser

Cost segregation is a popular tax planning technique for owners of depreciable real property. While it is a legitimate and sometimes beneficial technique, some taxpayers have adopted it without considering the potential adverse consequences that can occur upon disposition of the property. In particular, taxpayers and their advisers should be aware that cost segregation can result in later recognition of gain in a like-kind exchange of the property when gain otherwise would not have been recognized.

Cost segregation, also called componentization, reduces tax by accelerating depreciation on components of a building. Depreciation is accelerated by reclassifying components as five-, seven- or 15-year modified accelerated cost recovery system (MACRS) property rather than 39-year straight-line real property. This technique was revitalized in the case Hospital Corporation of America, in which the court allowed the taxpayer to categorize assets in a hospital  into many classes depending on their separate lives based on whether the assets could be removed from the building and a number of other factors. Assets such as lighting systems, movable walls, and ceiling grids were determined to be separable from the real property or supporting a separable activity and thus eligible for accelerated depreciation.

Examples of 15-year property include outdoor lighting, signage, and landscaping. Typical seven-year assets include floor and window coverings, decorative millwork, and electrical fixtures. Some assets identified in a componentization study may qualify for Sec. 179 expensing and/or bonus depreciation, which could further accelerate depreciation. These assets are not generally those that would be treated as personal property in a like-kind exchange as would appliances and other freestanding equipment.

Like-kind exchanges under Sec. 1031 allow a taxpayer to defer recognition of realized gains when exchanging property for like-kind property. Because of the broad definition of “like-kind” real estate, this technique is especially valuable to owners of commercial and  residential rental real estate. In fact, Sec. 1031 has spawned an entire industry of specialists who broker transactions and serve as qualified intermediaries in exchanges.

Similarly, componentization has caused the creation of firms that value buildings by asset class as well as advise on proper lives and potential future taxation. They evaluate a building and segregate its components into parts or segments that  normally are thought of as integral but could be considered removable and able to be categorized into depreciable classes.

This article has been excerpted from The Tax Adviser. View the full article here (PDF).