In any type of building, residential or commercial, there are real estate components, such as the structure itself, and there are personal property components. Personal property is the IRS term for items that are "movable" such as light fixtures, carpeting and window coverings. These type of personal property items are generally depreciated over 5 or 7 years, while the real estate components, the buildings themselves, are generally depreciated over 27.5, years (if the building is a residential structure such as an apartment building), or 39 years (if the building is a non-residential structure such as an office building).
What a cost seg study does is analyze the building and make a detailed allocation between the longer-life structural components of the building and the shorter-life personal property components. The benefit in doing this is the tax savings of recovering your investment faster by having more of the building allocated to items that are depreciated quicker.
For example, if you own an office building that you paid $10 million for, your annual depreciation deduction will run about $256,000 ($10,000,000/39), and if you're in the 35% bracket, your actual tax savings would be about $90,000.
Assume that you had a cost seg study performed on the building, and 20% of the structure was determined to be personal property with a life of 7 years. Now, your annual depreciation deduction on the personal property would be $286,000 ($2,000,000/7) and the revised annual depreciation deduction on the building would be $205,000 ($8,000,000/39), for a total depreciation deduction of $491,000, and a tax savings of almost $172,000. Your actual would even be substantially greater if you double the depreciation on the personal property (which you're allowed to do). In summary, a cost seg study, using my example, would have saved you in excess of $80,000 the first year alone.
So, how does the IRS feel about cost seg studies? While you'd think that they would be against them, the truth is that they encourage them. The reason is that most property owners arbitrarily set a percentage of the property as being personal property. This unsubstantiated percentage creates headaches for the IRS when they audit the property because, while everyone understands that a building contains personal property elements, the IRS can allow the allocation only if it is substantiated, which an arbitrary allocation is not. Cost seg studies, on the other hand, are typically performed by engineers who then prepare a final report which gives the building owner (as well as the IRS) the substantiation they need.
How do cost seg studies inter-play with 1031 exchanges? Most often the cost seg study is performed on the New Property after its purchase to complete the exchange. While I get a number of calls from clients worried about how an adjustment of the real vs. personal property allocations will affect their exchange, the answer is not at all if the cost seg study is undertaken after the New Property has been purchased.
The real problem affecting cost seg studies and 1031 exchanges happens if a cost seg study is performed on the Old Property immediately before the sale. This would create two potential problems: the first is that if there is significant personal property on the depreciation schedule at the time of the sale, the taxpayer would have to acquire an equal (or greater) amount of similar personal property on the purchase of the New Property. The second potential problem is that if a value greater than the undepreciated book value is allocated to the personal property in the sale, you would trigger depreciation recapture, which will be taxable, even though the property was subject to a 1031 exchange.
As a practical matter, while some technicians worry about these two events, in the real world I've never seen either event materialize - the first because owners contemplating the sale of a property in the near future would never incur the expense of a cost seg study (they'd wait and incur the expense on the purchase of the New Property) - the second because the residual value of the personal property, at the time of the sale, is considered insignificant and rarely valued separately.
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