Cost Segregation: Recapturing Energy-Related Cash Flow

"Cost segregation" is a business exercise for recovering wealth. The idea is to properly reclassify assets from a tax depreciation perspective that allows the owner to legally reduce tax liabilities and increase cash flows.

Here's how it works. A hybrid engineering/accounting exercise seeks to reclassify the assets that make up a subject property. All too often, an earlier accounting treatment of a property has assigned all features to a 39-year asset class for depreciation purposes. This includes the "bricks, sticks, and mortar" as well as the mechanical systems that condition the building's interior. Boilers, furnaces, air handlers, air conditioning systems, domestic water heating, and the like, are tossed into that same 39 year category. The mistake is that many of these systems have a much shorter functional life-- such as 15, seven, or even five years.

With all else being equal, it is advantageous to accelerate asset depreciation. Cost segregation analyses provide an inventory of systems that can be isolated from the building itself (a 39-year asset). This effectively increases near- to medium-term cash flows to the business. Income taxes avoided this way are added directly to annual cash flow. But here lies the one contradiction: if depreciation is accelerated, then annual expenses are increased. This is a good thing in that it reduces tax liabilities (and improves cash flow). However, this is bad from an operating margin perspective. What looks good from a cash flow perspective can actually make an operations manager look bad, because operating expenses increase directly with depreciation, reducing net operating (pre-tax) income.

To make a win-win situation, the organization’s finance and engineering leadership will obviously need to collaborate. Politically, it should be easy to do: you don't have to buy new machinery or force machine operators to change their habits. You don't take up people's time with awareness training. Everyone can "do it the way we've always done it" ...if in fact that's what you want.

But you can and should do better. The cash flows provided by cost segregation can be used to fund the first round of a solid business plan for continuous energy improvement. Such a plan would:
• start with a cost segregation analysis that identifies opportunities for accelerated depreciation;
• use the cash flow derived from this depreciation exercise to invest in energy-related assets that (1) sustain current production levels with less energy input, and (2) provide new investment tax credits or deductions; and
• reap the operating expense savings that the new energy investments provide.

What's it worth? To illustrate the financial impact of cost segregation, consider this: Each $100,000 in assets reclassified from a 39-year recovery period to a five-year recovery period results in approximately $16,000 in net-present-value savings, assuming a 5% discount rate and a 35% marginal tax rate.