Depreciation and Cost Segregation

Most commercial building owners are grossly overpaying federal income taxes because they are not depreciating their property as quickly as they should. A cost segregation study allows property owners to defer and reduce federal income taxes. When adequately performed by an appraiser with expertise in cost segregation, a conservative tax planning tool reduces federal income taxes by adequately allocating the cost basis between land, 5-year, 7-year, 15-year, 27.5-year, and 39-year property.

Cost Segregation Study Benefits
The benefits of a cost segregation study are substantial, immediate, and enduring. Year 1 federal income tax savings are typically at least two times the cost of a cost segregation study. In many cases, they are five to fifty times the cost of the study. The present value of federal income tax savings for a property held for ten years is typically at least ten times the cost of the study. In many cases, the present value of tax savings is as much as 30 to 50 times the cost of the report. The cost segregation study is only required once. Its cost is not recurring, but the benefits are recurring during property ownership. A cost segregation study can also materially reduce local property taxes by separating real and personal property for newly constructed properties.

Detailed Example
Preparing a cost segregation study requires only a little time commitment from the owner, perhaps 10 to 15 minutes. This limited-time commitment results in substantial tax savings, both conservative in approach and well documented. Some owners believe their accountant is properly segregating components into the proper classifications. Many accountants cannot thoroughly research this highly specialized field to understand the myriad of items that can be segregated and are inadvertently overstating their client’s income tax liability. Furthermore, not obtaining a cost segregation study increases exposure in an audit since there is no clear audit trail. A cost segregation study prepared by an appraiser with expertise in land valuation, construction costs, and market value documents each item. Further, a cost segregation expert can almost certainly sharply increase allowable depreciation.

Who Benefits from a Cost Segregation Study
Suppose you own real estate and pay federal income taxes or expect to during the ownership period for the property. In that case, you will benefit from the results of a cost segregation study. This is true whether the real estate owner is titled in a corporation, limited partnership, or limited liability corporation. A cost segregation study is appropriate for syndicators if limited partners receive material net taxable income during the holding period, even if the general partner does not currently pay federal income taxes. The cost segregation study will increase the depreciation shield, thereby decreasing and deferring federal income taxes for the investors.

Decreasing and Deferring Federal Taxes
Since a cost segregation study decreases and defers federal income taxes, let’s review the long-term impact of this deferral. Capital gains tax will be due if the owner does not enter into a 1031 exchange when the property is sold. However, capital gains tax rates are typically 20% – 25% for high net worth individuals, while the ordinary income tax rate is 35%. In addition, the deferral during the ownership period has material benefits because of the time value of money. All investors would much rather pay a 20% – 25% tax rate when an asset is sold instead of paying a 35% tax rate today.

When Should You Obtain A Cost Segregation Study
The best time to obtain a cost segregation study is to build or purchase a property. Documentation is most readily available for performing a study, and a recent property inspection can be performed to best document results. However, there are options to perform a cost segregation study for the property developed or purchased previously.

Elements of Preparing a Cost Segregation Study
The appraiser starts by gathering documents from the property owner and performing a site visit. As necessary, depending on the special-use property found during the site visit, the appraiser would confer with tax counsel and review relevant tax court decisions. For newly constructed properties, most of the detail of the costs can be obtained from construction draws or invoices from contractors. For existing properties, the appraiser performs a quantity take-off for 5-year, 7-year, and 15-year properties and estimates replacement cost using recognized sources. The appraiser then values land, 5-year, 7- year, 15-year, 27.5-year, and 39-year property based on the inspection, analysis, IRS regulations, and court rulings.

Does this only apply to large owners?
Large and small owners of income property or owner-occupied commercial property can benefit from a cost segregation study. Commercial properties with a cost basis of at least $200,000 will likely see a material benefit above the cost from a cost segregation study. Owners of single-family rental homes can probably achieve worthwhile benefits by obtaining a cost segregation study.

Qualifications to consider when ordering a Cost Segregation Report
Value land and real property are critical elements when engaging a tax reduction expert to perform a cost segregation study. In addition, they must have a detailed understanding of rules for classifying 5-year, 7-year, 15-year, 27.5-year, and 39-year properties. The ability to justifiably increase short-life depreciation materially increases the benefits of a cost segregation study. While most accounting professionals have a rudimentary understanding of the 5-year, 7-year, and 15-year property classifications, few have a detailed understanding of this highly specialized niche. Be sure the report provider has scrutinized both the federal income tax code and the meaningful tax court cases to allow you to maximize your depreciation and minimize your federal income tax liability.