By David J. Hawks |David J. Hawks
If you are a property owner, a cost segregation study can be a great way to accelerate depreciation deductions and save you money on your taxes.
What is Cost Segregation?
Cost segregation is a commonly used strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes. It does not increase the overall depreciation deduction; it simply accelerates it so you can take bigger deductions now instead of later.
What is a Cost Segregation Study & How Does it Work?
When a property is purchased, not only does it include a building structure, but it also includes all its interior and exterior components. On average, 20% to 40% of those components fall into tax class lives that can be written off much quicker than the building structure itself. A cost segregation study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 years for a residential rental property or 39 years for commercial property.
The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7, and 15 years. For example, certain electrical outlets that are dedicated to equipment such as appliances or computers should be depreciated over 5 years. Other examples of the 5-year property include appliances, carpeting, and furniture used in residential rentals.
A cost segregation study may also separate all the different building structural components (such as the roof, windows, or HVAC units) so that when they are replaced, a loss deduction can be claimed on them. The separation of property can also be beneficial for leased property, where tenant leasehold improvements receive favorable depreciation deductions.
What is Involved in a Cost Segregation Study?
A quality cost segregation study evaluates all information including available records, inspections, and interviews, and presents the findings in a clear, well-documented format. When gathering information for a cost segregations study, the following items will be helpful for a building that was purchased:
- 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, the list can include:
- Overall project costs
- General contractor costs and change order details
- Vendor invoices
- Construction drawings
The cost of the cost segregation study can vary by the provider along with the size and scope of the study but be prepared to spend thousands of dollars for this service.
What Should I Consider When Selecting a Cost Segregation Provider?
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 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.
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.
If you are a property owner, it may be time to look into the cost segregation study. There are many providers of this service so do your due diligence to find a reputable company that can support you in the event of an audit. Your CPA can help you incorporate the study into your tax return and claim the appropriate depreciation deduction that will save you money on your taxes.
If you need the help of a CPA who understands real estate taxation, you can call me at (480) 626-5557 or email me at firstname.lastname@example.org.