Cost Segregation is an extremely valuable tax planning tool that provides significant savings to real estate owners by increasing cash flows through accelerating depreciation deductions. As with anything in the “tax world”, there are variables that can affect the amount of savings a cost segregation study can produce, and additional complexity that can come from the real estate owner’s individual tax situation. Widespread misconceptions around these variables often lead taxpayers to leave a large amount of money on the table. Below are five common cost segregation misconceptions that our experts regularly observe:
- Cost Segregation is only a timing difference
While it is true that a building will eventually be fully depreciated in 27.5 or 39-years, cost segregation studies reclassify property into asset classes with shorter recovery periods such as 5, 7, and 15-year lives. Doing so takes advantage of the time value of money by generating large deductions early in the asset’s life. Deductions that are taken today will be much more valuable than deductions taken down the road. With inflation on the rise at a rapid pace, this timing difference is more valuable than ever. Real estate owners can take the savings a cost segregation study produces in the current year and reinvest it into their business, creating a higher return than the tax savings would from a depreciation deduction if the property was left in the former 27.5 or 39-year recovery period.
- Cost Segregation is not an option if property was placed into service in a prior year
Cost segregation studies can be performed on properties placed into service dating back to 1986. While it may not always make sense, an expert can help determine the magnitude of savings a study can produce on older properties. Often, real estate owners are deterred because they believe they will have to amend a return, which is not the case. Owners need to file a Form 3115 with their current year tax return, which will include a 481(a) “catch-up” depreciation adjustment. The “catch-up” depreciation amount is the difference between what should have been depreciated in prior years with the correct asset classifications and the amount that was depreciated in prior years. The taxpayer takes the full 481(a) deduction in the current tax year. An experienced cost segregation partner can help your accountant prepare the proper items on the return correctly as well as calculate the 481(a) adjustment that is included in the Form 3115.
- Cost segregation studies increase the chance of an audit
Taxpayers are often surprised to hear that the IRS supports cost segregation studies as long as they are completed within published guidelines. These guidelines are mentioned in the IRS Field Audit Techniques Guide (ATG), which details several elements for a quality study and report. The ATG covers guidance related to cost segregation including court cases specific to cost segregation, issue specific guidance, and industry specific guidance. Experienced partners can properly interpret the tax law surrounding cost segregation and build projects that withstand IRS scrutiny.
- Small properties with low tax basis do not make sense for cost segregation
With 100% bonus depreciation in effect through the end of 2022, real estate owners with small properties can realize significant savings from a cost segregation study. Properties with basis of a few hundred thousand can work depending on the property and project. For example, consider a taxpayer in the 35% tax bracket who completes a $350,000 renovation of a medical office space. This renovation includes replacing partitions, flooring, plumbing, electrical, HVAC, façade repairs, and new cabinetry. As a result of a study, there is a 45% reclassification into 15-year Qualified Improvement Property and 5-year personal property which are all eligible for 100% bonus depreciation. This study results in a first year accelerated depreciation deduction of $157,500 and a first-year increased cash flow of $55,125.
- Cost segregation will cost me more money down the road when I sell due to recapture
Cost segregation studies can create permanent tax savings for a property owner even if the owner plans to sell the property down the road; however, it is typically recommended that a property be held for at least three to five years after completing a study to realize benefits. While the holding period depends on each unique situation, these guidelines are a good starting point for planning. Although there might be some increased tax due at the time of sale due to recapture, this should not scare away property owners from completing a cost segregation study. The increased cash flow from the accelerated depreciation deductions offset ordinary income often outweigh the increased tax from recapture. This is because recapture is limited to the gain on the sale of the property and there is a reduction of value for the personal property from the time the property starts its depreciation to the time it is sold.
While there are others, these are the five most common misconceptions our team at McGuire Sponsel encounters when discussing cost segregation opportunities with our clients and partners. No one likes to leave money on the table when it comes to taxes, so consulting with an expert is the best path to ensure all opportunities for savings are identified. To discuss with our team further, contact us.
FAQs
The process will entail some cost and time. A study could cost as much as $20,000 or more, depending on the location, age of the property, and whether the building is residential or nonresidential. The study could take a month or more to complete.
What are the different types of cost segregation? ›
WHAT ARE THE MOST COMMON METHODOLOGIES UTILIZED FOR COST SEGREGATION STUDIES?
- Detailed Engineering Approach from Actual Cost Records.
- Detailed Engineering Cost Estimate Approach.
- Survey or Letter Approach.
- Residual Estimation Approach.
- Sampling or Modeling Approach.
- "Rule of Thumb" Approach.
A cost segregation study is a detailed analysis of the components of a building to identify assets that can be depreciated at a faster rate than the building itself. These assets can include things like carpeting, lighting fixtures, and heating/cooling systems.
What is the cost segregation model? ›
Cost segregation allows you to classify your real estate assets in such a way that you can benefit from accelerated depreciation. If you depreciate your assets on a shorter time schedule, then you will accelerate your depreciation deductions and reduce the amount of income tax you pay.
Does cost segregation make sense? ›
Cost segregation can certainly be “worth it” in terms of return on investment. Cost segregation fees vary, and are generally commensurate with a project's scope, size, and complexity.
What is cost segregation and what are the pros and cons to using it for tax purposes? ›
Cost segregation is a tax planning tool that gives real estate investors the chance to accelerate the depreciation of their investment properties. By doing this, they reduce their annual federal and state income tax payments, potentially freeing up their money for other investments or purchases.
What qualifies for cost segregation? ›
A cost segregation study surveys your building's subcomponents, like lighting fixtures, heating and air conditioning systems, and other components that deteriorate over time. It assigns five- or 15-year lifespans to these subcomponents.
Who is eligible for cost segregation? ›
Residential and non-residential commercial properties are prime candidates for cost segregation studies. These analyses are not limited to traditional office buildings or apartment complexes; they also apply to specialized facilities such as: Manufacturing plants.
Which method is better to segregate the cost? ›
One of the most common methods of cost segregation is a detailed engineering approach from actual cost records. This method is generally for new construction where detailed costs are available and it provides the most accurate cost allocations.
Can I do a cost segregation study yourself? ›
Nearly anyone can do a basic cost segregation study which may include some component breakout, but doing it right is the issue. It is fair to say that CPAs, appraisers, contractors, and others can breakdown some of the building components and apply a life to them, especially on new construction.
If you're a real estate investor or property owner, you've probably heard about cost segregation and how it can help you maximize tax benefits. But can you do cost segregation on residential rental property? The answer is “yes.”
Can you do cost segregation for an Airbnb? ›
Cost segregation is a powerful tax-saving strategy that can substantially impact your financial success as an Airbnb, Vrbo, HomeAway, or 9flat host. KBKG's Residential Cost Segregation® is the ultimate tool to help you navigate the complexities of residential cost segregation and unlock its full potential.
Can cost segregation offset capital gains? ›
Using Cost Segregation to Offset Capital Gains
If you don't have enough current or suspended losses to offset this capital gain, you can purchase a new property and use a cost segregation study to create current passive losses that can offset the gain.
Can you do a cost segregation study on a 1031 exchange? ›
Based on these interpretations of the applicable tax laws for depreciation and IRC Sec. 1031, with proper planning and guidance from tax professionals, real estate investors can still take advantage of cost segregation along with 1031 exchanges.
Who can benefit from cost segregation? ›
Any real estate owner facing tax liabilities generally benefits from a comprehensive cost segregation study. Ideal candidates are corporations, partnerships, trusts, and individuals with: Newly purchased or constructed property worth a basis allocated to the building of more than $1 million.
How far back can you do a cost segregation study? ›
Ideally, a cost segregation study is performed in the year of the acquisition, construction, or renovation of a property. Businesses can also have look-back studies where cost segregation is performed on buildings built, acquired, or renovated within the past 10 years.
Can you amend a tax return for cost segregation? ›
4. Can I amend a return for cost segregation from last year? Once an accounting method is established after filing two tax returns, you are required to file a 3115 to correct depreciation. If the property was acquired last year, you can amend last year's return to claim missed deductions.
What are the tax benefits of cost segregation study? ›
Reduced tax liability: By classifying the various components of your property, a cost segregation study can help you claim accelerated depreciation on certain components, which means you'll pay less in taxes.
