For a real estate investor or property owner, a cost segregation study is an opportunity that can offer significant tax savings. To help understand this tax strategy and how it can benefit a property or portfolio, here are 10 key questions and answers about cost segregation.
What is a cost segregation study?
Cost segregation is a tax deferral strategy that frontloads depreciation deductions for real estate assets into the early years of ownership. A study segregates the cost components of a building into the proper asset classifications and recovery periods for federal and state income tax purposes. This generally results in significantly shorter tax lives for these components—typically five-, seven- and 15-years—rather than the standard depreciation periods of 27.5 years for residential rental property or 39 years for non-residential real property.
How does a cost segregation study work?
A cost segregation study can reduce tax liability and increase cash flow in the early years of real estate ownership. The cash flow increase from a study’s tax savings can then be invested in a business or used as appropriate.
Here’s a typical process.
1. Conduct a feasibility analysis
A cost segregation study begins with a feasibility analysis, which is a complimentary estimate of the potential benefits and fees to perform a study for the specific buildings.
During this step, your accountant should take time to understand the property owner’s tax position and the significant property characteristics to give a reliable estimate of the benefits a study could provide.
2. Gather additional information
The next step is to gather additional information.
For a building that was purchased by the taxpayer, this can include:
- An appraisal
- A property condition report
- An American Land Title Association (ALTA) survey or site map
- The closing purchase documents for a study being done on the acquisition of a property
For a building that was constructed or remodeled by the taxpayer, this can include:
- Overall project costs
- General contractor costs and change order details
- Vendor invoices
- Construction drawings
3. Analyze the property
The next step analyzes the property and provided information, which typically includes the following:
- Completing an on-site tour of the property
- Examining all drawings and other relevant documents
- Classifying all cost information and estimates, including the personal property within the buildings and land improvements around the site
4. Complete a report
The final step is the completion of a full report, which often includes:
- Results of the study
- Methodology
- Photos of the property
- Tax law supporting the asset classifications
This report should be retained as long as you own or occupy the property. It provides support for asset classifications and can be used in case of an audit by tax authorities.
What are the tax benefits of a cost segregation study?
The benefits from a cost segregation study will vary based on the depreciable basis of the improvements, property type and the amount of short-life assets the property has. The benefit from cost segregation is derived from the identification of short-life property—for instance, five-, seven- or 15- year property—and other items that can be immediately expensed.
The overall reclassification of assets to short-life property commonly ranges between 10% and 40% of the depreciable cost basis, based on the property type. For example, an office building or apartment property will usually have more short-life property than a warehouse building.
Additional savings opportunities can be achieved in reviewing the cost-seg information that may apply to:
– Section Section 179D: A Section 179D Energy Efficiency Commercial Building Deduction study is a tax savings service that can be complementary with a cost segregation study for newly constructed or remodeled buildings, if the building envelope, HVAC and lighting systems meet or exceed certain energy efficiency standards.
The benefits from a Section 179D study can be up to $5 per sq. ft. starting in 2023, if certain prevailing wage and apprenticeship requirements are met.
– Section 45L: The Inflation Reduction Act retroactively extended the existing credit through 2022, with modifications starting in 2023. In general, the Section 45L tax credit provides incentives for residential homebuilders and multifamily developers to reduce energy consumption in newly constructed residences by offering a per dwelling unit tax credit.
The act increased the maximum credit provided to contractors. Originally $2,000 per unit, it’s now increased to $5,000 per unit with the addition of the Zero Energy Ready Homes certification and a prevailing wage option.
What are the potential pitfalls of a cost segregation study?
When short-life assets found in a cost segregation study are sold, they can be subject to depreciation recapture at the taxpayer’s ordinary income tax rate instead of capital gain tax rate. However, recapture might be less of a concern the longer the taxpayer holds the asset.
Oftentimes, the benefits of cost segregation outweigh the additional tax due to recapture when the taxpayer holds the property for greater than three to five years. A quality cost segregation study should provide references and other documentation to support the study’s tax positions. Regardless, if the tax authority disagrees with the support and tax positions, the taxpayer could be subject to penalties by the IRS and other tax authorities for understating income due to the results of the cost segregation study.
Cost segregation studies, like other tax records, are subject to IRS review. However, one of the main purposes of performing a cost segregation study is to provide the necessary support for taxpayer deductions.
A reputable service provider can provide a quality report. Here’s what to look for when evaluating service providers:
- Adherence to IRS guidelines. A reputable accounting service provider will follow IRS guidelines to help reduce risk while striving to increase your depreciation and the corresponding tax savings.
- Inclusion of a final report. A good service provider will also provide you with a cost segregation report that can be used if the IRS questions the results of the study.
- Support. The cost segregation provider should be available to assist in resolving questions and issues with the IRS or other tax authorities should the cost segregation get audited.
Is your business a good candidate for a cost segregation study?
Real estate owners with tax liabilities can benefit from a cost segregation study. Good candidates are corporations, partnerships, individuals, and trusts who can use the benefits of accelerated depreciation with:
- Newly constructed or purchased property greater than $1 million
- Remodel, renovation, or leasehold improvements greater than $300,000
When should you have a cost segregation study performed?
Construction projects: If you have a new construction project that can benefit from cost segregation, a study can be started during construction to help gather the necessary cost details and construction information.
However, you’ll need to know the final costs before your team can complete the study and before filing a tax return for the year the new construction project is placed in service.
Purchased properties: If you have a purchased property that can benefit from cost segregation, a study needs to be completed before the tax return is filed for the tax year the property was acquired.
Look-back studies: Cost segregation studies can also perform look-back studies for assets placed into service in a prior tax year. Your service provider will follow a similar process to that listed above, but they’ll also prepare a Form 3115, Application for Change in Accounting Method.
This allows the catch-up of allowable depreciation for the tax year the Form 3115 is filed.
How long will a cost segregation study take?
A typical cost segregation study takes between four and eight weeks to complete from the time all relevant information is collected. This timeframe includes:
- The information-gathering process
- An in-person walkthrough of the subject property
- The analysis itself
- A review process to confirm the tax positions are supportable
Can you complete your own cost segregation study?
While you could identify the basic short life assets within a building, it’s important to work with a tax professional to get cost segregation right and to find the full value.
The IRS has laid out guidance for the different approaches to cost segregation studies, as well as which techniques are more reliable and accepted as quality methods.
Rule of thumb approach: Within this guidance, the IRS mentions the rule of thumb approach, which is simply estimating the short-life property within a building by using a percentage of short-life property found in other buildings of a similar type.
While this type of cost segregation automating is quick and cheap, the IRS doesn’t consider it reliable. Should a company or cost segregation provider use this technique, it leaves them open to audit risk.
Engineering approach: A quality service provider will use a detailed engineering approach from actual cost records, as well as a detailed engineering approach cost estimate approach, both of which are recommended by the IRS to provide the most accurate and trusted cost segregation results.
How often do you need a cost segregation study?
A cost segregation study can be performed once for each property that a taxpayer builds, acquires or inherits. However, if any significant improvements are made to the property after it’s placed into service, these improvements are opportunities for additional cost segregation studies and additional depreciation deductions.
For example, building additions such as expansions or building remodels are significant improvements that can benefit from a new cost segregation analysis.
If another taxpayer acquires a property that previously received a cost segregation study, the IRS recommends a new cost segregation study for the new owner because the circumstances of the property will be different for the new owner.
How much does a cost segregation study cost?
Typical fees from advisors and services firms are based on the estimated time it will take to complete the cost seg analysis and report. Factors affecting fees include the size of the property, property type, available information, property location, uniqueness of building, number of tenants, the business activity of the tenants and complexity of tax considerations.
Jason Thompson is a partner, tax credits & incentive services, for Moss Adams LLP.