What is cost segregation? Cost segregation is a federal income tax strategy that allows property owners to accelerate depreciation deductions, ultimately enhancing cash flow and deferring tax payments. 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.
Advantage of a Cost Seg Study
For this reason, many of our clients take advantage of cost segregation to accelerate depreciation deductions, reduce tax liability, increase cash flow, and perpetually “kick the can down the road.” This tax planning idea works for both commercial property as well as residential rental properties. And the IRS has blessed cost segregation studies on many occasions.
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. Performing a cost segregation analysis is a critical tool for property owners to maximize tax savings by accelerating depreciation deductions. Capitalization of property components is part of this process, ensuring that each component is properly classified for tax purposes.
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. The tax benefits of reclassifying property components into shorter depreciation lifespans can significantly improve cash flow and financial success in real estate investments.
In addition to faster depreciation, taxpayers may also take 80% bonus depreciation for all 5, 7, and 15 year property in 2023. Bonus depreciation is currently scheduled to be reduced by 20% per year after 2023. Despite the phaseout of bonus depreciation, the potential tax benefits of cost segregation remains significant.
Cost Seg Study Report
The results of a cost segregation study are contained in a cost seg study report. This report should be given to your tax preparer, to ensure that the tax returns properly include the tax benefits of the study. The cost segregation report should be kept with your tax records. A properly written report should be based on all IRS guidelines and is a powerful rebuttal in case of an IRS audit.
Strategic Tax Planning: Tax Savings and More
Cost segregation is a strategic tax planning tool offered by CPA firms and other tax specialists. In most cases, the net effect of a cost segregation study allows most property owners to depreciate up to 25% of their building in Year 1! This massive amount of depreciation allows taxpayers to offset taxable income, thus reducing their tax liability and keeping more money in their pockets to invest in future deals.
Cost Seg Study: Understanding Timing Differences
Cost segregation is a tax deferral strategy. It 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. Tax deductions play a crucial role in reducing tax liabilities and enhancing cash flow. 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 IRS asks any questions.
It is important to note that cost segregation does not increase depreciation. Rather, it 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.
Cost Segregation Study: Accelerated Depreciation
Cost segregation studies are used to accelerate depreciation and increase deductions. Asset reclassification is a key part of the cost segregation process, as it involves shifting costs from longer to shorter depreciation periods. They generate 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 a Cost Segregation Study Work
Cost segregation analysis, also known as component analysis, is the process of categorizing building expenses into various depreciation 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 for a commercial real estate investment property:
- Property records
- Ownership of the property
- Address
- 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
- Construction cost details, relating to the building structure and other components
- Property improvements
- Appraisals
- Inspection reports
- Engineering reports
- Tax returns, tax workpapers and summaries of depreciation expenses
A cost segregation study may also require a physical inspection of the property, especially for high dollar real estate investments.
Cost Segregation Study for Real Estate: An Example
In this example of a cost seg study, we are asked by a client to perform an analysis of a commercial property, specifically an office building in Atlanta.
Here are the key facts for the cost segregation study:
- Building cost basis: $6,320,000
- Land value: $680,000
- Depreciation before cost segregation study: $162,051
The capital expenditure involved in this case study was significant, reflecting the substantial investment in the property.
Here are the results of the cost segregation study:
- Depreciation in Year 1 after cost segregation study (including bonus depreciation): $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
Real Estate Investors
Many commercial real estate investments larger rental properties are held in partnerships or LLCs, owned by real estate investors. These are taxed as “pass through” entities for income tax purposes. As such, the tax benefits of cost segregation studies pass through to the individual real estate investors, to be deducted on their personal tax returns. These tax benefits consist primarily of accelerated depreciation and bonus depreciation to be deducted in the earlier years of property ownership.
Real estate investors in situations like this will benefit significantly from cost segregation studies, as a result of enhanced profitability and cash flow from the project.
Good Candidates for a Cost Segregation Study
Any structure used for business is eligible for the potential tax savings of cost segregation studies. Residential rental property is also eligible for cost segregation benefits, which can maximize tax deductions and minimize tax burdens. The tax law provides that leasehold improvements or renovation costs may also be considered as qualified property for this purpose.
Ideal candidates for a cost segregation project are:
- Commercial properties 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, under the appropriate tax laws for those entities.
- 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 a Cost Segregation Study?
The ideal time for a Cost Segregation Study can vary depending on an owner’s tax situation. Cost segregation is a tax planning strategy. 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 Study Review
Massey and Company CPA provides a preliminary review of potential cost segregation projects at no charge, including a detailed cost/benefit analysis. Our preliminary review is a feasibility analysis that 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.
Call us at 678-235-5460 (Atlanta) or 773-828-0551 (Chicago) to discuss Cost Segregation in detail. Or email me directly at gary.massey@masseyandcompanycpa.com. Be sure to ask for your no-cost feasibility analysis 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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