Making Real Estate Payoff in More Ways than One
Investment in real estate, whether for direct business use to house your operating business, or to invest to lease to tenants who pay the underlying mortgage, taxes and insurance, the long-term purpose inevitably boils down to obtaining significant capital appreciation and income generating benefits. Regardless, mitigating tax ramifications over time is every investor’s potential goal.
Prior to 1986, utilizing accelerated depreciation increased passive expenses and could be used to offset ordinary income. The Tax Reform Act of 1986 significantly changed those tax benefits. Subsequently, one needs to utilize the opportunities that come to bear with legislation periodically passed by the United State Congress and the dispositions relevant to the body politic at the time. One tax savings concept that has stood the test of time and many presidential administrations has been the Cost Segregation Study.
Under United States tax laws and accounting rules, cost segregation is the process of identifying personal property assets that are grouped with real property assets and separating out personal assets or “land improvements” for tax reporting purposes. This permits the taxpayer to optimize depreciation deductions, resulting in substantial cash flow benefits.
Personal property assets include a building’s non-structural elements, exterior land improvements and indirect construction costs. A cost segregation study will allow a taxpayer to reclassify these assets as Section 1245 property with shorter useful lives for depreciation purposes, rather than the useful life for Section 1250 property. Specifically, it identifies all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for non-residential real property), thereby assisting the taxpayer in future write-offs as renovations or repairs occur. Personal property assets generally include items that are affixed to the building but do not relate to the overall operation and maintenance of the building.
Land Improvements generally include items located outside a building that are affixed to the land and do not relate to the overall operation and maintenance of a building. Decreasing the tax life of these items and improvements brings accelerated depreciation deductions, tax savings, and increased cash flow. Land improvements can include car ports, retaining walls, block walls, fencing, concrete stairs, dumpster enclosures, paved areas, site utilities, walk ways, sidewalks, parking lots, curbing, concrete stairs, fencing, and landscaping. Landscaping itself can be separated into plants, trees, shrubs, sod, mulch, rock, and security lighting.
Recent tax law changes under the Tax Cuts and Jobs Act of 2017 (TCJA) have given a boost to cost segregation. Bonus depreciation was increased from 50% to 100% on certain qualifying assets. Real estate investors will receive immediate expensing of certain 5, 7- and 15-year property. TCJA also allows used property that was acquired after Sept. 27, 2017 to qualify for this special depreciation treatment. A quality cost segregation will separate any costs that qualify under the new bonus depreciation rules. Furthermore, IRS affirms cost segregation as a legitimate method for determining the useful life of building components. This has been held up in various court decisions and IRS publications, including its own Audit Guide, which not only confirms this position, but also lists several relevant court cases.
Are You a Good Candidate for Cost Segregation?
Cost segregation studies on real estate property are usually performed during the year of acquisition or construction. Regardless, a study can be completed at any time after a building is placed in service – even if it has been many years. A Cost Segregation benefit can be applied retroactively to existing properties through a Sec. 481(a) catch-up adjustment allows you to receive substantial benefit with your next tax filing. This adjustment brings accelerated depreciation benefits from prior years into the current year as one single adjustment. The result is often a substantial reduction of current year tax liability.
If you have purchased real estate post-1986, and its acquisition or improvement value is in excess of $500,000, a cost segregation study should be considered if you:
Buildings eligible can include:
There are situations where Cost Segregation Studies should not be performed to accelerate depreciation. These may include situations where you plan to flip the property in less than three years or where the taxpayer is in a long-term loss for tax purposes. If you plan to utilize a tax-free exchange under the Section 1031 tax-deferred Exchange provisions, a cost segregation study will maximize your use of Section 1250 property, accelerating depreciation on that property, and not subject you to the unrecaptured Section 1250 tax rate of 25%. In this case, you can almost have your cake and eat it too – tax savings while you own the property and tax deferral when you sell the property. Nonetheless, consult your tax advisor if you face these types of situations.
Cost segregation requires an understanding of the complexities of the tax code and of the materials and methods of construction design. Grennan Fender utilizes professionals with civil, structural and architectural engineering knowledge to identify components that qualify for accelerated depreciation. All actual and estimated asset costs along with their classifications are then documented to withstand IRS scrutiny.
Sample Preliminary Cost Segregation Study Sample
Net Present Value of Tax Savings
Acquired Mixed Use – Orlando, FL
9,770 SF Single Story Mixed Use – 5.7 Acres, Built 1984, Class B
Pre-tax Discount Rate 7.000%
After-tax Discount Rate 4.550%
Tax Year of Change 2017
Month Fiscal Year Ends (1 – 12) 12
Date in Service 04/18/2012
|Before Cost Segregation Study|
|After Cost Segregation Study|
|Description||Building||Land||Info Sys||Trade/Svs||Furniture Fixtures & Equip.||Manf-Electrical||Land|
|Method||Straight Line||N/A||200% Double Bonus||200%|
|Life||39 years||N/A||5 years||5 years||7 years||7 years||15 years|
Year by Year Analysis
|Before Cost Segregation||After Cost Segregation|
|Info Systems||Trade Services||Furniture, Fixtures, Equip.||Land Improve||Total||Better/Worse|
Tax Benefit @ Year 6
|Accelerated Depreciation Carryforward to Year 6||Tax Benefit @35% tax rate||Net Present Value of Tax Benefit|
If you are planning to construct, purchase or remodel a building, Grennan Fender can conduct a free preliminary analysis to determine how much benefit a cost segregation study can deliver. Please contact us at: firstname.lastname@example.org.