What a Sample Cost Segregation Report Looks Like—and Why It Could Save Your Cannabis Business Thousands
Cannabis businesses are constantly challenged by federal and state tax laws that limit business deductions and over-inflate taxable revenue. Cost segregation is a tax-planning strategy that enables any cannabis business that has purchased new real property or has expanded or remodeled existing real estate to reduce taxes, increase cash flow, and accelerate depreciation, effectively deferring federal and state taxes payable.
Essentially, cost segregation is a method of identifying personal property assets grouped with tangible property assets and reallocating these costs for tax reporting purposes. By leveraging this method, cannabis businesses can significantly reduce their tax burden—but it must be completed correctly, which means enlisting the help of an engineer.
To segregate costs accurately, they must be divided into four categories:
Personal property
Land improvements
Building components
Land
Improvements to leased or existing buildings can also qualify under the following conditions:
Qualified leasehold improvements qualify for 15-year depreciation, referring to internal upgrades made to leased property before it is put into service.
Qualified improvement property refers to upgrades made to the interiors of the commercial property after the fact. So, for instance, new HVAC systems, roofing, security, fire protection, etc.
While this method can be applied to any commercial real estate, it is particularly helpful in the cannabis industry as it shortens the depreciation time on much more than just the land itself when categorized into personal property.
After cost segregation, assets that would typically be locked in as a fixed asset at 39.5 years depreciation would now qualify for 5, 7, and 15-year depreciation schedules as personal property, vs. the 39.5 years assigned to the property itself. This strategy would effectively reduce taxable income and increase cash flow in the first few years after the investment.
How Does Cost Segregation Work?
As previously stated, cost segregation studies require qualified engineering expertise. The federal government controls the process and mandates such expertise to ensure compliance.
During the process, each building and component is considered and classified either as real property (structures, roofs, buildings, walls, foundations, etc.) or personal property (flooring, electrical systems, machinery, furniture, fixtures, equipment, plumbing, window treatments, lighting systems, etc.).
Each component is then assigned its own depreciation schedule, significantly accelerating depreciation for many components and resulting in nice tax deductions you would not ordinarily have if lumping all categories together.
Depreciation is critical when it comes to taxes, as it allows the business owner to spread the value of the asset over several years. The fewer years, the greater the depreciation value in the short term. This rule recognizes that such assets lose value over time and allows owners to recover some of the value of the item to allocate to replacements in the future.
Getting Started with a Cost Segregation Study
Qualified, reputable experts must conduct detailed cost segregation studies. If you are initiating this process through your accounting firm, they will enlist the services of experts in engineering and tax law in addition to their in-house accounting expertise.
The process is typically carried out in four phases.
Feasibility analysis. This step determines whether the property is eligible for cost segregation. An engineer will inspect various components, including plumbing, electrical, roofing, flooring, HVAC, etc.
Information gathering. You will need to provide the inspectors with various documentation to determine the value of the building and all abovementioned systems, as applicable. For real property, you may be asked to provide a recent property appraisal and inspection reports or closing documents related to the property’s purchase. Have these handy and ready when requested.
Property analysis. Your team (accountant, engineer, tax specialist) will assess operating costs eligible for depreciation over 5, 7, or 15 years. You may need to provide blueprints, inspection reports, property records, deeds, etc., to inform this analysis.
Report completion. A report is issued that can then be leveraged to determine your tax savings based on the results.
Pros and Cons of Cost Segregation Studies
While there are many potential benefits to be had with cost segregation, there are also a few caveats to be aware of.
On the plus side, cannabis businesses can reclassify some assets to allow for accelerated depreciation and significant tax savings in the short term. In these early years following the purchase and cost segregation study, the company can reduce its tax burden and increase cash flow accordingly. Operational costs are optimized as segregation helps you manage assets more efficiently.
On the downside, cost segregation studies can be costly as they require specialized expertise. As such, the practice might not be suitable for smaller operations. Then, there is the time and resource commitment, as the process can be incredibly time-consuming.
Lastly, since the IRS governs the cost segregation process, businesses choosing to go this route can expect additional scrutiny from the feds. Audits should be anticipated, so be prepared—and ensure your team meticulously documents every step to support every deduction.
Is a Cost Segregation Study Worth it for Your Cannabis Operation?
Financial and reporting implications should be carefully considered before undertaking a cost segregation study. Studies can cost in the realm of $5,000 to $15,000, depending on the size and complexity of the assets and property in question (source).
Keep in mind that this is something you shouldn’t undertake on your own—unless you are an engineer or have the specific expertise required to complete the documentation correctly.
For some businesses, the benefits far outweigh the costs as the process can deliver substantial tax savings and increased cash flow in an otherwise fraught tax environment. If you choose to go this route, ensure your documentation is letter-perfect and your books are squeaky clean, as you can almost certainly expect an audit.
Working with the tax and accounting experts at Growise can help you leverage all the positives of a cost segregation study while minimizing the concerns.
Set up a consultation today to get the ball rolling, and let’s see where your growth can take you.