A few weeks ago I wrote about the massive tax benefits to investment property owners and business owners who also own commercial real estate using a cost segregation study. Some of you took me up on the offer and now are up for a significant tax reduction. Then the problems started. I didn’t anticipate the large number of tax professionals who didn’t know how to handle cost segregation studies on a tax return.
Before you call your tax preparer bad names, know most tax professionals rarely, if ever, see a cost segregation study in their office. When the rules changed a few years back I doubt 1 in 100 accountants handled their client tax returns correctly as it pertained to the repair regs and tangible property rules. The good news is the changes only required certain actions in the first year of accounting method changes. The bad news is that most tax professionals don’t know how to handle a cost segregation study on the actual tax return when a client comes in with one. Not to worry. Your favorite accountant will spill the beans on how to get it done right. No picking on your accountant either. This is advanced tax planning and tax law can be miles from tax application at times.
Tax professionals will find this helpful; taxpayers should find value, too. Knowing of a tax advantage is only worth something if you can apply it. There are two major issues surrounding cost segregation studies: tracking the components/elements listed by the study and taking full advantage of the additional depreciation allowed.
Reading the Cost Segregation Report
When you get your report it will list the building components by item and class. In most cases you will see components listed under 5-year, 15-year, and either 27.5- or 39-year property, depending if it is residential or commercial real estate. Sometimes a component will also fall under 7-year property.
It is important to add each item separately to the depreciation schedule, even the 27.5- or 39-year property. The 5- and 15-year property accelerates the current depreciation deduction. But even the long end of the depreciation schedule has value. The roof, doors, electrical, plumbing and painting eventually need upgrading. When you upgrade any component you deduct the remaining undepreciated basis left in the replaced component.
The same applies to short end of the depreciation schedule. The parking lot, sidewalk and landscaping are 15-year properties. A replacement of any of these will trigger the remaining basis for deduction of said component.
The original estimate of tax savings from a cost segregation study underestimates the benefits as it assumes only the increased depreciation expense related to the 5- and 15-year property. There are only a few components that are not replaced prior to the component being depreciated. The foundation is one such item. But even things like plumbing and electrical are likely to need an upgrade before 39 years!
The advantage of the cost segregation study is the separate listing of components. The additional deduction from the old component (when replaced) helps offset the cost of the upgrade. Coupled with the repair regs, investment property owners and businesses with commercial real estate are better able to match deductions with the outlay of capital. A difficult issue in business and with landlords is the outlay of cash to improve a property only to wait up to 39 to get a tax benefit. Without a cost segregation study the cash is spent on the improvement and also taxed currently, increasing the cash needs to undertake a project. Cost segregation and the repair regs help eliminate some of the problem, allowing more projects to move forward.
Preparing the Tax Return
The concept of the cost segregation study is easy to understand. Then you run into the issue of application. Accelerated depreciation causes problems unless you make certain elections on your tax return.
Investment property owners need to consider passive activity rules. Once income reaches six figures, passive activity rules suspend some or all losses until the passive activity has a gain or is disposed of.
The normal structure of many small businesses makes passive activity rules an acute problem. It is common for small businesses to conduct business as an S corporation or an LLC treated as an S corporation. Real estate should never be held inside an S corp. Therefore, real estate is usually held in a second LLC treated as a disregarded entity by the same owners. In many instances this real estate does not generate enough rental income to handle all the additional depreciation from the cost segregation study. Passive activity rules kick in and undo all the cost segregation advantages.
This is where grouping comes in. The IRS says you can group activities using any “reasonable method”. This is a wide road to travel. It isn’t a free-for-all, but as long as the group of activities constitutes an appropriate economic unit the grouping should be allowed. The implications to passive activity rules are significant.
There are five factors in determining if a group constitutes an economic unit: 1.) similarities and differences in the activities; 2.) extent of common control; 3.) extent of common ownership; 4.) geographical location; and 5.) interdependencies between the activities. Once a grouping is made it cannot be changed unless the original grouping was inappropriate, the facts and circ*mstances change, or the IRS disallowed the original grouping.
Because of the interrelated nature of the real estate used by an entity to conduct business, grouping of the two activities is a reasonable step to take. Landlords can also group activities in a similar fashion.
Grouping allows the business and the real estate profits to be combined. The real estate fair rental value paid by the business may not be enough to generate a gain and passive activity rules then limit the loss. By grouping the business with the real estate used by the business, the accelerated depreciation resulting from a cost segregation study is now possible to currently deduct.
One final note: A disclosure is required when grouping activities. The structure of your business determines the type of disclosure required. Partnerships and S corporations already have rules in place requiring a disclosure attachment to Schedules K-1.
Form 3115
There is one more monster in the room: Form 3115, Change in Accounting Method. Form 3115 has been revamped over the last few years and is now down to 8 pages. Not to be afraid. You only fill out the portions of the form applicable to your situation. If time permits, I will write a post this summer with a filled-in Form 3115 as it applies to cost segregation studies. The best news of all is that if you do the cost segregation study the first year the property is owned there is no need to file Form 3115. You only need to file Form 3115 to catch up on depreciation you should have used all the prior years.
This is a complex area of tax code. I recommend hiring a tax professional to handle grouping issues. Your accountant may not work with grouping often, but she has all the books and resources available to prepare the tax return properly with all regulations considered. And they will are more likely to make the required elections and disclosures, protecting you in an audit.
For more information you can read this post with step-by-step instructions on applying a cost segregation study to a tax return, including a filled-in Form 3115.
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