Cost segregation is a tax strategy that allows businesses to identify and classify certain assets in a way that allows for faster depreciation of those assets. This can result in significant tax savings for the business, as it can reduce the amount of income subject to tax in the current year.
Modified Accelerated Cost Recovery System, or MACRS, is a method of depreciation used in the United States to determine the amount of depreciation expense that can be recognized for tax purposes. It was introduced as part of the Tax Reform Act of 1986 and has been in use ever since.
Under MACRS, businesses can elect to depreciate certain assets over shorter periods of time than would normally be allowed under the General Depreciation System (GDS). This results in a larger amount of depreciation expense being recognized in the early years of an asset's life, which can provide a tax benefit to the business.
One key concept in MACRs cost segregation is the distinction between land value and improvement value. Land value is the value of the land itself, without any improvements such as buildings or other structures. Improvement value, on the other hand, refers to the value of any improvements made to the land, such as buildings, roads, or utilities.
Under MACRs, land value is not depreciable, as it is considered to have an indefinite useful life. Improvement value, however, is depreciable, and the business can elect to use MACRs to depreciate these assets over a shorter period of time than would normally be allowed under GDS.
To determine the improvement value of an asset, it is necessary to first determine the total cost of the asset. This includes not only the cost of construction, but also any related costs such as architects' fees, permits, and financing costs. Once the total cost of the asset has been determined, the land value is subtracted to arrive at the improvement value.
What is improvement value?
Improvement value is the portion of a property’s value assigned to buildings, structures, site improvements, and other depreciable assets on the land. In cost segregation, improvement value matters because it is the starting point for depreciation. Land itself is not depreciable, but buildings and qualifying improvements can be depreciated under MACRS.
How is improvement value calculated?
Improvement value is calculated by subtracting land value from the total property value or purchase price. The basic formula is:
Total property value - land value = improvement value
For cost segregation, the land value usually comes from a county assessor allocation, third-party appraisal, purchase price allocation, or another supportable valuation method. Once land is removed, the remaining improvement value can be analyzed for 5-, 7-, 15-, 27.5-, or 39-year depreciation categories.
Is land improvement depreciable?
Yes, land improvements can be depreciable, but land itself is not. Depreciable land improvements generally include assets added to land, such as parking lots, sidewalks, fencing, landscaping, irrigation systems, drainage, and exterior lighting. Many land improvements are depreciated over 15 years and may qualify for bonus depreciation if the tax rules are met.
Worked example: land value vs. improvement value allocation
A business purchases a commercial property for $600,000. A county assessor record or appraisal supports a $100,000 land value. The remaining $500,000 is improvement value.
- Total purchase price: $600,000
- Land value: $100,000
- Improvement value: $500,000
- Depreciable basis before cost segregation: $500,000
A cost segregation study then breaks the $500,000 improvement value into shorter-life and long-life assets:
- 5-year property: $75,000
- 15-year land improvements: $50,000
- 39-year building property: $375,000
In this example, the $100,000 land value is not depreciable. The $500,000 improvement value is depreciable, and $125,000 of that improvement value may qualify for accelerated depreciation through cost segregation.
Under GDS, the business would generally depreciate the building portion over 39 years. Under MACRS with cost segregation, qualifying improvement value can be separated into shorter recovery periods, which creates larger deductions in the early years of ownership.
In summary, MACRs cost segregation is a tax strategy that allows businesses to identify and classify certain assets in a way that allows for faster depreciation of those assets. By distinguishing between land value and improvement value and electing to use MACRs to depreciate the improvement value, businesses can potentially save significant amounts in taxes.
