Can You Benefit from a Cost Segregation Study?
Your real estate may be eligible for a cost segregation study, (to help you accelerate depreciation tax deductions) and you may not even know it. Here are some ways to know if you can benefit from a cost segregation study.
What is a Cost Segregation Study?
The term “cost segregation” refers to the process of identifying and classifying the subcomponents or units of property. With real estate, this includes identifying tangible property, land improvements, and the building and its structural components.
The cost segregation study can produce significant tax deductions given that our tax laws assign different class lives or periods for which you can take depreciation tax deductions for some of these subcomponents. For example, decorative light fixtures might qualify for a short five-year life; whereas, an elevator may only qualify for a longer 27.5 or 39-year life. If you have owned the real estate for several years, more than five years in this example, and you are depreciating your decorative light fixtures over 27.5 or 39 years, a cost segregation study may allow you to deduct the full undepreciated cost for the fixtures this year given that the five years (the correct class life) has already passed.
When you consider that 20 to 30 percent of a building will typically qualify for a shorter class life, you can see how this first-year depreciation deduction can produce a very large deduction in the year the cost segregation study is performed. This ability to deduct up to 20% to 30% of the cost of the building in the study year, rather than taking smaller deductions over 27.5 or 39 years, is the primary benefit of the cost segregation study.
What Properties Make Sense for a Cost Segregation Study?
Business and Rental Real Estate
Properties can benefit from a cost segregation study as long as they are property that qualifies for depreciation deductions. This includes most buildings and structures that are either used in a business or held for rental income. It does not include raw land. Personal residences also do not qualify.
Newly Acquired or Constructed Property
Newly acquired or constructed property can also benefit from a cost segregation study. Not only does the cost segregation study identify the class lives for depreciation, it also identifies the units of property that qualify for Section 179 expensing for newly acquired or constructed property.
Section 179 expensing is different than depreciation. Section 179 expensing allows an immediate deduction for certain equipment, etc. in the year it is acquired. Section 179 expensing is taken in lieu of depreciation. The recent changes in the law added some real estate components to the list of property that qualify under Section 179, such as roofs and HVAC units. The cost segregation study can help you realize these expenses currently rather than depreciating them over their class lives.
Similarly, the cost segregation study will help identify the property that qualifies for bonus depreciation. Given the recent changes in the law, bonus depreciation can provide a 100 percent deduction for the cost of qualifying property for the first year the property is placed in service. The new law also says that used property–not just new property–can qualify for bonus depreciation. This means that you can take 100 percent bonus depreciation when you purchase real estate.
Recently Sold Real Estate
A property may still be a good candidate for a cost segregation study even if you recently sold it. As long as you sold the property and have not yet filed the tax return to report the sale, there can be an opportunity to do a cost segregation study to begin maximizing tax deductions in the year of the sale.
The benefit of post-sale cost segregation studies relates to the tax rate savings. Depreciation deductions, including a large final year catch-up depreciation deduction, taken in the final year will generally offset income taxed at ordinary tax rates. This tax deduction reduces the tax basis in the property and, as such, increases the gain on the sale of the property. Assuming the property was held for more than a year, however, the increased gain will be taxed at the much lower capital gains tax rates. This is where the tax benefit comes in–the reduction of income taxed at higher ordinary tax rates versus the increase in gains subject to lower capital gains tax rates.
Tenants can also benefit from cost segregation studies given that tenant improvements may also qualify for depreciation. Even small tenant improvement can produce significant tax savings given that they may qualify for 100% bonus depreciation under the new tax rules.
Common Misconceptions About Cost Segregation
The Tax Benefit
There is a misconception that real estate that is valued at less than $1 million would not benefit from a cost segregation study. The belief is that the fees would to perform the cost segregation study would outweigh the benefit. This is not always the case. Cost segregation studies can make sense for real estate valued at as little as $500,000.
There is another misconception about real estate that does not have a lot of personal property associated with it. Industrial warehouses provide an example. It is often thought that there is no benefit to doing a cost segregation study for these properties. This isn’t true.
There can still be a significant benefit because these properties generally have a significant amount of land improvements. Land improvements generally have a much shorter class life than the building or structure. They may also have certain portions of electrical, mechanical, and plumbing that can also qualify for shorter class lives. A cost segregation study can help you realize these tax benefits sooner rather than later.
There is a misconception that a cost segregation study will result in more tax given the recapture tax rules. These rules effectively require that certain accelerated deductions be paid back out of the sales proceeds at the time of the sale.
This overlooks the value of the disposition rules and how they interact with recapture taxes. The disposition rules allow you to write off assets that are disposed of. A cost segregation study can identify those assets that were disposed of or that will be disposed of. Then, when the disposition occurs, there is no gain or loss to recapture on those assets. This can help avoid recapture taxes.
To learn more and find out if a Cost Segregation is right for your business, contact our tax experts at Innovative CPA Group. Call us at (203) 489-0612, or contact us online.
Heidi Henderson, Executive Vice President, Engineered Tax Services, February 28, 2018. Reprinted with permission.