By Christina S. Porter

There are many things an investor must take into account when evaluating the pros and cons of an investment and specifically, how and if it will fit into their long and/or short term plan. A key component in an investment analysis is the relationship between risk and reward, and how best to maximize the reward and minimize the risk.

Depreciation can assist an investor in capitalizing on the reward by improving the after tax cash flow. Cost segregation is an increasingly popular form of asset depreciation. It is unique compared to the standard straight line depreciation in that it is used for parts of a property that, from a tax standpoint, are usually incorporated into the building and therefore automatically included in the 39-year straight line depreciation, or 27.5 years for residential income properties.

Using cost segregation allows a property owner to divide the building into components and depreciate each one separately, some of which are most likely eligible to be assigned a shorter tax life, allowing for larger depreciation amounts sooner and effectively increasing your immediate cash flow. Examples are carpet, lighting systems and wall coverings. Another considerable advantage to cost segregation is that separately depreciating each component of a building — even if it is over the same time period — allows a property owner to more quickly and easily write off the cost of a component of the building that has failed. Examples are a roof, or an HVAC system.

A taxpayer can use cost segregation when constructing a building, buying an existing one and sometimes even years after owning or selling one, depending on the date of disposition. When using cost segregation, a property owner must distinguish between parts of a property that are considered “real property” and “tangible personal property,” the latter of which usually affords a much shorter tax life. This is where you can run into trouble. The ability to distinguish between tangible personal property and a building made up of its structural components is an area of great controversy.

In an article written by Jay Soled and Charles Falk, “Cost Segregation Applied,” the authors state that in deciding a case, the tax court came up with the following questions that, when answered, would qualify an asset as “tangible personal property” or a “structural component:”

- Can the property be moved? Has it been moved? For example, a shed with a concrete floor versus a shed with a wooden floor.

- How difficult is removal of the property, and how time-consuming is it? For example, a wine cellar versus a prefabricated photo-processing lab.

- Is the property designed or constructed to remain permanently in place? For example, a wooden barn versus a wire chicken coop.

- Are there circumstances that tend to show the expected or intended length of affixation, or that the property may or will have to be moved? For example, permanent concrete pilings versus floating docks that can be removed in the winter.

- How much damage will the property sustain upon its removal? For example, a steel-encased bank vault versus an easily removable lighting system attached by bolts.

- How is the property affixed to the land? For example, permanently glued bathroom tile vs. removable billboard.

There are some challenges to cost segregation. The most significant being the cost of an engineering study — a necessity — to identify the types of assets and whether they are personal property or structural components, which can be prohibitive. It can enhance the benefits of a 1031 exchange. However, it could also further complicate the transaction.

An investor must be certain that all of the rules are followed very carefully. All of this must be discussed with your tax professional prior to making any investment decision.

(You can reach Christina Porter at 1-877-4 TM 1031, or e-mail her at Christina@tm1031exchange.com to discuss your specific needs. TM 1031 Exchange assists investors in planning and executing successful real estate investment strategies. Visit www.tm1031exchange.com for a complete list of investment properties and to download the TM 1031 Tool Kit.)