6-minute read
A cost segregation study seeks to identify and speed up depreciation deductions. It also helps you defer state and federal income taxes. Thus, you end up increasing your cash flow.
Essentially, the cost study stands as a strategic tax planning tool. It applies to corporations and individuals that have purchased, constructed, remodeled, or expanded any real estate.
How it works
When you purchase a building, it comprises the interior and exterior features. Commonly, 20%-40% of the features fall in the tax categories that get written off quickly compared to the building structure itself.
Some components of your property fall under section 1245 property (personal property). The rest falls under section 1250 property (real property).
The study comes up with four distinct asset classes:
- Personal property
- Building or structure
- Land
- Land improvements
The segregation sets apart the purchase price or construction cost that has a depreciation period of 27.5-39 years. It identifies the property-related costs with a depreciation period of 5, 7, and 15 years. For example, some accessories attached to equipment have a depreciation period of 5 years.
Personal property, including furniture, fixtures, window treatments, and carpeting, have 5-7 depreciable years. Land improvements, including landscaping and sidewalks, have a 15-year depreciable life. Any building or structure has a depreciable life of 27.5 or 39 years. Last, land does not depreciate but having the proper documentation for its value prevents an IRS taxation challenge.
All components that attach to a structure or building are not personal property, but they are structural components. So, structural components include some lighting fixtures, plumbing and wiring, and air conditioning systems.
During the study, there is an evaluation of all information from interviews, records, and inspections. The information relates to the cost details, blueprints, and physical inspection of the property. In the absence of the said information, then the study uses the estimated component values.
You can carry out cost segregation after purchasing, remodeling, or constructing your property. If you are a new owner, then the most ideal time to carry out the segregation study is the year of purchase, remodel, or construction of your property.
Investors that are planning phases of construction or remodeling should carry out the study before setting the building infrastructure.
Benefits
Cash flow
The cost segregation study results in an immediate cash flow increase because it speeds up the depreciation deductions. It helps you shelter more taxable income in the current fiscal year. Thus, the study helps you defer the payment of your income tax as a commercial realtor.
If you employ the permissible bounds to value your personal property as high as possible, then you will gain a highly valued tax premium.
Under the cost segregation, land improvements depreciate at a 150% reducing balance method. Using a high valuation of the land under permissible bounds also helps you to get a high tax deduction premium.
The study also lowers the local realty-transfer taxes. The local authority imposes tax according to the fair market value of a building. The segregation of costs lowers the value of a building, thus reducing the net realizable transfer tax. Also, there is a high possibility for a reduction of the annual real estate tax.
Overall, the study helps you achieve time value for your money. The study results in front-loaded deductions that are greater than the spread deductions.
Write off
You can write off major components of your property after renovating or replacing them. Using an adjusted tax basis that lowers the initial cost of a component calls for a replacement of the component. Subsequently, there is a loss that comes from the replacement cost. Segregating the cost helps you write off the tax basis instead of incurring it as a cost.
Review
The study provides an independent third-party analysis that qualifies for IRS review. Certified Public Accountant (CPAs) that carry out the study are qualified professionals, and IRS recognizes their skills. Thus, their analysis report stands as a credible document in the eyes of the IRS.
Qualification
If you are a commercial realtor that uses property purchased or build after 1986, then you can carry out a cost segregation study. If your property qualifies for the study, then you should approach a CPA to help you make an application.
The CPAs apply an accelerated cost recovery system (ACRS) to calculate the amount of deduction to make from your income tax.
Overcoming the drawbacks
Even though there are costs related to undertaking cost segregation, you can deduct the cost as a business expense as per the IRS section 162. You can also engage a CPA to overcome the challenges of tax code recapture and engineering misinformation. Thus, you will avoid any penalty that emanates from the two challenges.
Can you do without cost segregation?
You can decide to consider the cost segregation as a high-risk tax shelter and avoid it. However, the permissible depreciation method is equally aggressive to using cost segregation when using a well-structured engineering report. You can easily identify the land and building improvements, thus claiming tax benefits successfully.
Summary
The benefits of using the cost segregation study outwit its drawbacks. Even though drawbacks exist, there is a solution for them. The study helps you to realize significant tax deductions you cannot achieve when spreading the deductions over a long time.
It is time to approach your CPA, learn more about the study, and start the cost segregation process.