Cost segregation is a widely accepted tax planning strategy that may be highly beneficial. Cost segregation can add massive acceleration to the depreciation deductions you claim on a building. That savings can add up to a lot of money in your pocket. Depreciation is an annual allowance for the deterioration and wear and tear of the property.
Generally, commercial buildings are depreciable over 39 years. Residental rental buildings are depreciable over 27.5 years. But, imagine how much more you could save if your depreciation deductions if 30 percent of your buildings could be depreciated using 5-year depreciation, rather than 27 or 39-year depreciation!
This is possible. It is possible with a building you already own and have owned for some years. It can also happen with a building you want to buy. It can happen with an upcoming renovation.
A cost segregation study calls for dividing a building into two parts: personal property and land improvement. When you utilize the cost segregation strategy, you realize deductions faster.
Here’s an example:
A $10 million building that segregated into:
- $2 million of equipment (20%)
- $2 million of land improvements (20%)
- $6 million of building (60%)
It’s important to look at the percentages. Had this building cost $1 million, rather than $10 million, the percentages could have been the same. You may have an office in your home with similar percentages. Consider that 20 percent of this building qualified for five-year rather than 27.5-or-39-year depreciation, while another 20 percent qualified for 15-year depreciation. The bottom line is a major difference in the timing of deductions. The saying time is money applies here–the timing advantage may produce huge financial benefits.
Tax law allows for the depreciation of buildings, land improvements, and equipment to zero. The aforementioned $10 million building can produce $10 million in depreciation. Cost segregation accelerates your deductions. If your deductions provide tax benefits, you can get the cash benefits earlier and use that money sooner for your other investments. Here’s another example. If you:
- Earn 6% after taxes on your investments
- Are in the 50% tax bracket and
- Have $2 million that you could depreciate using either the 5-year modified accelerated cost recovery system (MACRS) or the 39-year straight-line depreciation schedule.
Using a present value of six percent to put your tax refunds into today’s dollars, it would mean:
- $852,624 in today’s dollars if you used MACRS depreciation, or
- $382,427 in today’s dollars if you used 39-year straight-line depreciation
In this specific example, you are nearly $500,000 (223%) better off with the faster depreciation. Cost segregation typically results in real savings. This is significant difference is what makes cost segregation so valuable.
Are You Eligible for Big Benefits?
Generally, cost segregation works when you will:
- Benefit from the faster deductions
- Benefit from the time-value of money
- Spend less on the cost segregation study than you earn in cash benefits
The next consideration is the length of time you will own the building. The longer you keep the building, the greater the benefit from cost segregation. Other factors are how many rental properties you own and how long you plan to own them. With proper planning, you can use a section 1031 exchange to defer taxes, and also to carry the segregation benefits from one building to another.
The cost of the study is the final factor to consider. Segregation studies can be reasonably priced, and often the benefits outweigh the cost.
Cost segregation has many business advantages, including:
- Rapid depreciation (allows you to put the time-value of money to work for you)
- Look-back depreciation on a building you own but have never used cost segregation
- Immediate write-off for the cost of the segregation study as a business expense in the year the study is performed
- Section 179 expensing on qualifying personal property assets (typically in commercial buildings and home offices)
- A one-time big adjustment that you might want to use when you have a specific tax issue (claim the prior years’ depreciation in one lump sum in the year of adjustment, using IRS Form 3115)
- Asset replacement identification for accelerated write-offs
- Lower transfer taxes because the cost of the personal property was separated from that of the real property
- Lower property taxes (depends on the taxes that apply to personal property and those that apply to real property)
- No user fee payable to the IRS to make the accounting change. (Typically, people who make an accounting change have to pay a $2,500 fee to the IRS, although with gross income of less than $250,000, the fee is $625.)
The recapture tax on real property may be less than the depreciation recapture tax on personal property.
When it’s time to sell, consider this: the depreciation claimed on personal property is recaptured as ordinary income at rates up to 35 percent. The gain attributable to depreciation of real property is taxed at a maximum rate of 25 percent. The longer you wait before you sell, the less effect the depreciation recapture taxes will have. Also, you may not be in the 35 percent rate bracket at the time you are ready to sell.
Engaging a Tax Professional
To maximize the advantages of a cost segregation study, you should engage qualified tax professionals like the ones at Advanced Tax Advisors in Plantation, Florida. If you use a tax professional and send the paperwork to the IRS properly, you will suffer no increased risk of an IRS audit because of the cost segregation study.
When to Perform your Look-Back Cost Segregation Study
When you are ready to conduct your look-back cost segregation study, you enter the price segregation depreciation modifications using an automatic change in accounting, which you can do for free and with automatic approval from the IRS. But the tax agency does not give automatic approval every time you apply. Automatic approval is grant once. After that, there is a five-year waiting period, or you have to go through the IRS for approval. It’s recommended that you do cost segregation on all of your properties at the same time. If you are going to change the depreciation in your business office, rental property, and home office, you should do it all in a single filing.
Other Times to Consider a Cost Segregation
You may want to think about a cost segregation study if you receive an inheritance. For example, if your spouse dies and you inherit property with a stepped-up basis. You may use cost segregation on the inheritance to allocate basis to land and equipment improvements. You may also want to mention cost segregation of property to your heirs as it may be a significant benefit when they inherit the property after your death.
Cost segregation can create financial benefits for buildings you already own and buildings you plan to buy. The savings are easy to calculate. Cost segregation is one of the few investments you can make that typically guarantees your rate of return.