A cost segregation study is a strategic tax savings tool that allows companies and individuals who have purchased, constructed, expanded, or remodeled any kind of real estate for commercial or residential use to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes.
Typically, real estate is depreciated over a straight-line period – 27.5 years for residential and 39 years for commercial. While the straight-line method is a predictable and consistent method of depreciation, it is often not the optimal or prudent decision for most real estate owners and often unnecessarily increases a client’s tax liability.
For this reason, many of our clients take advantage of cost segregation to accelerated depreciation deductions, reduce tax liability, increase cash flow, and perpetually “kick the can down the road.”
Using a Cost Segregation Study to Reduces Taxes on Real Estate
The primary goal of a cost segregation study is to identify the various components of a property and classify them in various class lives.
Components of a building can be broken down into 5, 7, 15, 27.5 or 39 year class lives. The point of cost segregation is to identify, or “segregate,” those assets which can be reclassified from 27.5 or 39 year property to 5, 7 or 15 year property. This results in faster depreciation of certain components of commercial buildings and rental real estate.
In addition to faster depreciation, taxpayers may also take 80% bonus depreciation for all 5, 7, and 15 year property in 2023. Bonus deprecation is currently scheduled to be reduced by 20% per year after 2023.
Strategic Tax Planning
In most cases, the net effect of a cost segregation study allows most taxpayers to depreciate up 25% of their building in Year 1! This massive amount of depreciation allows taxpayers to offset taxable income, thus reducing tax their tax liability and keeping more money in their pockets to invest in future deals.
Cost segregation is an excellent idea for strategic tax planning. And the audit risk is minimal. It has been approved by the IRS for years and has been in use since 1998. With a formal report of a cost segregation study in your business files, the benefits of this tax planning strategy are fully defensible in case the the IRS asks any questions.
It is important to note that cost segregation does not increase depreciation. Rather, is accelerates depreciation, resulting in increased cash flow in the earlier years of ownership of the property.
Cost segregation is a “time value of money” concept. In other words, cost segregation is based on the principle that a dollar today is worth more than the same dollar in the future.
Benefits of Accelerated Depreciation
Cost segregation is used to accelerate depreciation. It generates a significant increase in depreciation deductions within the first 5 years of owning the property.
Assuming a combined tax rate of 41% and a return on investment factor of 8%, every $100,000 of costs shifted from 39-year property to 5-year property creates a present value tax benefit of approximately $22,000.
Every $100,000 of costs shifted from 39-year property to 15-year property creates a present value tax benefit of approximately $12,000.
How Does Cost Segregation Work
Cost segregation is the categorization of the expenses of a building or rental property into various “buckets.” Here is a summary of the buckets:
- Expenses depreciated over 27.5 or 39 years: Roof, walls, windows, foundation
- Expenses depreciated over 15 years: Land improvements, such as paving, sidewalks, pools, shrubbery, landscaping, retaining walls, fences, roadways, pathways
- Expenses depreciated over 5 or 7 years: carpets, laminate flooring, cabinets, counters, moldings, specialty plumbing, decorative lighting fixtures, ceiling fans, certain types of wiring
- Soft costs allocable to the various buckets: specialty consulting, permitting, accounting, legal, architectural and engineering fees, contractor overhead and profit
- Land – not depreciable
As a tax planning strategy, cost segregation moves expenses from the 27.5 or 39 year bucket into the 5, 7 or 15 year buckets.
What Information is Needed for a Cost Seg Study?
The following information is required (or at least helpful) in order to perform a cost segregation study:
- Ownership of the property
- Placed-in-service date
- Number of units
- Number of tenants
- Number of stories
- Square footage
- Closing statement for purchased property
- Final AIA documents or contracts for new construction
- Most recent tax returns, including depreciation schedules
- Blueprints for original construction and improvements
Cost Segregation: A Case Study
In this case study, we are asked by a client to perform a cost segregation study for an office building in Atlanta.
Here are the key facts:
- Building cost basis: $6,320,000
- Land value: $680,000
- Depreciation before cost segregation study: $162,051
Here are the results of the cost segregation study:
- Depreciation in Year 1 after cost segregation study: $3,243,443
- Income tax savings in Year 1: $1,243,424
- Net present value of tax savings: $850,341
- Benefit to cost ratio: 120:1
Good Candidates for a Cost Segregation Study
Any structure used for business or as rental property is eligible for the benefits of Cost Segregation. Leasehold improvements or renovation costs may also qualify.
Ideal candidates for a cost segregation project are:
- Buildings acquired, improved, renovated or built in the last 15 years.
- Building with a cost of $750,000 or more for a freestanding building (not including land).
- Improvements to a building of $500,000 or more.
- Smaller residential properties with more than $150,000 of cost basis (not including land).
- Owner is paying state or federal income tax. Taxable income is required to enjoy a tax benefit from a cost segregation study.
- Properties that will be held for 5 or more years. Depreciation recapture can be an issue for short-term holders (unless they do a 1031 exchange).
- REITs that are interested in controlling dividend distributions to shareholders
- Energy efficient retrofits.
Examples of good candidates for cost segregation include offices of doctors and dentists, warehouses, laboratories, multi-family rental properties, shopping centers, office buildings and restaurants and commercial kitchens.
When is a Good Time for Cost Segregation?
The ideal time for a Cost Segregation Study can vary depending on an owner’s tax situation. Although the optimum time for a study is during the year a building is constructed, purchased, or remodeled, a study can be completed anytime afterward. In fact, current IRS procedures make it easy to go back and claim missed depreciation on assets acquired as far back as 1987 without amending prior tax returns.
Our real estate experts will determine when cost segregation make sense for you.
At a minimum, do let your CPA know as soon as possible when you purchase or renovate commercial real estate or rental properties. You want to allow sufficient time to determine the potential benefit of this tax planning strategy.
Ask for a Free Preliminary Cost Segregation Review
Massey and Company CPA provides a preliminary review of potential cost segregation projects at no charge. Our preliminary review includes a cost/benefit analysis which will help you to decide if a Cost Segregation Study makes sense for your real estate investment.
For a more general review of taxes and real estate, check out our Guide to Tax Rules for Rental Real Estate.
Or email us at firstname.lastname@example.org. Be sure to ask for your no-cost preliminary review based on your specific set of facts!
Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, IRS audit defense, sales tax, and small business accounting and bookkeeping.
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