Cost Segregation – A Tax Savings Strategy

Tax savings through cost segregation is no longer out of reach for investors in small and medium-size properties. With appraiser expertise, fees for analysis are often one-third to one-half lower than those charged by traditional preparers.

Several years ago, a classic court case ruled that tangible personal property included in an acquisition or overall costs should be depreciated as personal property for asset recovery, using the old Investment Tax Credit principles to classify personal property.

This meant that owners of improved properties could distinguish between real property and personal property to depreciate component costs over varying useful lives. Specific components are correctly identified as depreciating in much less time instead of depreciating an entire commercial property over 39 years or residential property (single-family rentals or multifamily) over 27.5 years. For about 135 items, applicable life periods can be 5, 7, or 15 years. This is known as cost segregation.

The increase in depreciation is lower taxable income (which would have been taxed at 35%) and more income taxed at the capital gains rate (15%) when the property is sold. Furthermore, it works for any improved property.

Until recently, primarily large accounting firms or engineering firms implemented cost segregation studies, addressing large and newly built properties and sometimes outsourcing the analysis.
Prices for those analytical reports, usually in the $10,000 to $40,000 range, were out of reach for owners of small properties, especially those holding less-than-new assets. Unfortunately, those owners representing the largest segment of real estate investors in the country were overlooked mainly by previous providers of cost segregation services.

A revolutionary paradigm shift is opening the door to very significant savings for owners of small properties. Much of the change is based upon introducing the efficiencies of highly knowledgeable real estate appraisers who often apply industry-accepted cost estimation techniques before determining the remaining asset life. Professional fees are lower by not “over-engineering” the staffing or production process. Yet, results can usually meet or exceed far more expensive reports. IRS auditors have successfully field-tested this approach.

Changes that appraisers are introducing to cost segregation analysis and reporting are addressing: 1) the size of the property being analyzed, 2) the age of the property, and 3) an affordable price point. You can take advantage of such techniques to affect these beneficial changes:

1. Property owners with an improvement basis as low as $500,000 can benefit from cost segregation. This compares to the limited properties worth $5 to $10 million and above that previously benefited.
2. Existing properties built or purchased after 1986 offer significant savings in year one of cost segregation, even without producing original cost documents. Capturing non-segregated depreciation from prior years is perfectly allowable by the IRS. This compares to firms previously applying the methodology only to new construction.
3. Fees are no longer prohibitive. To prepare an analysis and report for many small properties, prices are low enough to generate at least three times the report cost in the first year.

This compares to the standard fees ranging from $10,000 to $20,000 and up for comparable properties.
It is wise to keep the owner’s CPA or tax preparer abreast throughout the process. For older properties, the CPA may need to complete a Form 3115 to submit with the tax return so the owner can realize savings on items not previously depreciated – without filing an amended return.

Income-producing properties worth as little as $500,000 can achieve a 3:1 payback ratio of tax savings over the modest price of a cost segregation report. If owned for three or more years, the typical payback ratio is 10:1.

As owners prepare for federal tax filings, many are tapping into this opportunity to lower their federal taxes. General partners who are not paying federal income taxes should use this depreciation method since K-1s will reflect lower taxable income to benefit their limited partners.