Cost segregation of building components can shorten recovery periods of the affected parts of a taxpayer’s building and therefore accelerate deductions for depreciation. However, taxpayers must be wary of potentially unfavorable side effects of cost segregation.
These side effects include, in taxable exchanges of cost-segregated property, possible recapture of depreciation under Sec. 1245, subjecting it to an ordinary income tax rate potentially higher than the 25% recapture rate for real property under Sec. 1250. This recapture can be a particular hazard for boot gain realized in like-kind exchanges. An additional complication for cost-segregated property in a like-kind exchange is the requirement that components be grouped according to kind or class.
However, the interplay of cost segregation with bonus depreciation rules is often taxpayer friendly, particularly given a recent liberal IRS definition of “components” of self-constructed property qualifying for bonus depreciation.
Cost segregation can complicate allocating costs to deductible repairs rather than capitalizing them, since the IRS is scrutinizing accounting method change requests where the taxpayer’s definition of “unit of property” may have changed.
Other possible considerations for taxpayers using cost segregation include alternative minimum tax liability and cost segregation’s effect on the domestic production activities deduction.
Larry Maples (lmaples@tnstate.edu) and Robert D. Hayes (rhayes@tnstate.edu) are professor of accounting and professor emeritus, respectively, at Tennessee State University in Nashville, Tenn.
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