Cost segregation studies can be a valuable tool for real estate owners to accelerate depreciation deductions and potentially reduce their current tax liability. However, there are restrictions, qualifiers, and other important considerations. Here’s a breakdown of some FAQs asked by clients:
What are some restrictions on the use of cost segregation studies in real estate?
- Property Must Be Placed in Service: The property must have been purchased and placed in service for use in a trade or business or for the production of income. You can’t perform a cost segregation study on a property you haven’t started using for its intended purpose.
- Timing: While a cost segregation study is most beneficial when done shortly after acquisition or construction, it can also be performed on existing properties that were placed in service in prior years. This is often done through a “look-back” study.
- Accuracy and Reasonableness: The allocations of costs to different asset categories must be reasonable and based on factual information. The IRS can challenge studies that are deemed overly aggressive or lack proper documentation.
- Cost of the Study: While not a legal restriction, the cost of a qualified cost segregation study can be a practical restriction, especially for smaller properties where the potential tax savings might not outweigh the expense.
- IRS Scrutiny: While not a restriction on use, properties with significant cost segregation deductions might be subject to greater scrutiny during an IRS audit. However, a well-documented and properly performed study generally holds up.
What are the qualifiers?
- Type of Property: Cost segregation studies are most beneficial for commercial properties, rental properties, and certain types of residential rental properties. They are generally less impactful for personal residences.
- Ownership: The owner must be using the property in a trade or business or holding it for the production of income (e.g., rental income).
- Significant Investment: Properties that have undergone significant construction, renovation, or acquisition costs are the best candidates for cost segregation. The larger the investment in personal property-like assets, the greater the potential tax benefits.
- No Specific Income Level: There isn’t a specific income level required to qualify for a cost segregation study. The benefit is tied to the property’s characteristics and how it’s used.
Does it apply to all asset types?
Cost segregation primarily focuses on distinguishing between real property (which has longer depreciation periods like 27.5 years for residential rental or 39 years for commercial) and personal property (which has shorter depreciation periods like 5, 7, or 15 years).
- Real Property: This includes the structural components of a building, such as walls, floors, roofs, and permanent fixtures.
- Personal Property: This includes items that are not permanently affixed to the building and are typically more easily removed. Examples include:
- Certain types of flooring (e.g., some carpets, vinyl)
- Specialized electrical and plumbing systems serving specific equipment
- Removable wall coverings
- Appliances (depending on how they are affixed)
- Landscaping directly related to the business operation
- Furniture and fixtures used in the business
While the concept can technically be applied to any real estate, the benefit is less significant for properties with minimal personal property components. Land itself is not depreciable.
Is there a downside?
Yes, there are potential downsides:
- Cost of the Study: A professional cost segregation study can be expensive, ranging from a few thousand to tens of thousands of dollars depending on the size and complexity of the property.
- Potential for Recapture: When the property is eventually sold, the portion of the gain attributable to the depreciation taken on the personal property is generally taxed as ordinary income (recaptured depreciation), rather than at potentially lower capital gains rates. This essentially means you’re accelerating the tax deduction now, but you’ll pay more in taxes later on that specific portion of the gain.
- IRS Scrutiny (as mentioned earlier): While not necessarily a downside if the study is done correctly, it’s a factor to be aware of.
- Complexity: Understanding and implementing the results of a cost segregation study can add complexity to your tax filings.
How long is a new owner required to hold the property after a cost segregation is done?
There is no specific required holding period after a cost segregation study is performed. The benefits of accelerated depreciation are realized annually as long as you own the property and it continues to be used in a trade or business or for the production of income. Your decision to sell the property is independent of the cost segregation study.
Does the cost segregation impact the basis on federal taxes?
Yes, cost segregation impacts the adjusted basis of the property for federal tax purposes. While the initial basis (usually the purchase price plus certain acquisition costs) remains the same, the basis is reduced each year by the amount of depreciation you take, including the accelerated depreciation identified through cost segregation.
What is the tax impact over the short and long term?
- Short Term (While You Own the Property):
- Increased Depreciation Deductions: The primary short-term impact is a significant increase in depreciation deductions in the early years of ownership. This is because a larger portion of the property’s cost is classified as personal property with shorter depreciation lives.
- Lower Taxable Income: The increased depreciation deductions reduce your taxable income in the current year, leading to lower income tax liability.
- Improved Cash Flow: The tax savings can improve your cash flow in the short term.
- Long Term (Upon Sale of the Property):
- Lower Adjusted Basis: Due to the higher depreciation taken over the years, the adjusted basis of the property will be lower at the time of sale compared to if you had only depreciated it as real property.
- Potential for Recaptured Depreciation: When you sell the property at a gain, the portion of the gain equal to the depreciation you previously claimed on the personal property will be taxed as ordinary income (recaptured depreciation). The remaining gain (if any) will be taxed at capital gains rates.
- Overall Tax Benefit: Even with the recapture, the time value of money often makes cost segregation beneficial. Receiving tax savings earlier can be more valuable than paying slightly more in taxes later.
Important Note: Tax laws are complex and subject to change. This information is for general guidance only and should not be considered tax advice. It is crucial to consult with a qualified tax advisor or CPA to determine if a cost segregation study is appropriate for your specific situation and to understand the potential tax implications. They can analyze your property, financial situation, and the current tax laws to provide tailored advice.
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