$538,344 – That’s the 250% increase in tax deductions over the first 5 years of ownership for a real estate investor who had a cost segregation study performed on his recently acquired 30,000-square-foot strip mall. Large real estate developers and Fortune 500 companies have been using cost segregation studies over the past two decades to increase cash flow on their real estate holdings. However, partnerships and private investors often overlook this IRS-approved tax saving strategy due to a lack of awareness.
How Cost Segregation Works
Costs associated with acquiring, constructing, or improving a building can be deducted from one’s tax bill over decades. 39 years is the default period for most buildings, while 27.5 is the default period for apartment buildings. A cost segregation study uses accounting and engineering methods to correctly identify certain assets in and around a building so that they can be written off more rapidly compared to those default periods. These faster write-offs apply to both federal and state income taxes, allowing for significant cash flow increases. For example, $39,000 invested into a building would allow for a yearly tax deduction of about $1,000 over a period of 39 years. However, if a cost segregation study changed the depreciation period from 39 years to 5 years, the yearly deduction would be almost $8,000 over a period of 5 years – an eightfold increase in tax deductions. This acceleration of tax deductions is what has made cost segregation studies popular with the savvy investor.
One of the easiest ways to picture how cost segregation works is to look at a building as one bucket of costs versus four separate buckets of costs. Initially, a building can be considered entirely as 39-year property. That’s the “one-bucket” approach. A cost segregation study identifies a building’s assets and allocated costs that can be written off over 5, 7, 15 and 39-year periods: the “four-bucket” approach. Although the “one-bucket” approach is easiest, it is also the most costly because it makes an incorrect assumption that deprives a taxpayer of savings he or she is entitled to. By contrast, the “four-bucket” approach correctly gives the taxpayer three additional shorter recovery periods that allow for immediate tax savings.
Several building assets qualify for inclusion in these shorter write-off periods. Some examples include certain electrical outlets, telephone/data outlets, kitchen sinks and piping, carpeting, vinyl flooring, decorative and excessive lighting, parking lots, landscaping, and more. The rules governing whether assets qualify for these shorter recovery periods are very complex. Additionally, knowledge of the construction process and experience in cost estimating, cost allocation, and blueprint analysis is necessary for what the IRS deems a “quality” cost segregation study according to its Cost Segregation Audit Techniques Guide.
Cost segregation can be used as a stand-alone strategy or in addition to other tax strategies to make the benefits even greater. A large portion of real estate transactions throughout the country are made through 1031 exchanges because they allow for taxes to be deferred and allow for acquisitions of even larger properties. By combining cost segregation studies with 1031 exchanges, real estate investors can grow their portfolios more quickly since they can continue to maintain large tax deductions while deferring gains at each sale. For taxpayers that constructed new buildings or improvements between September 11, 2001 and December 31, 2004, cost segregation studies allow for certain improvement costs to qualify for a 30 to 50% bonus depreciation deduction in the first year. Other than certain leasehold improvements, this valuable tax write-off was only applicable to improvements with a recovery period of 20 years or less. Since a cost segregation study identifies the three additional “buckets” that qualify for this limited write-off, it provides even greater immediate savings in this scenario. Other additional benefits of a cost segregation study include the ability to identify tax-deductible demolition costs and even to create multiple opportunities for deductions on the same property using estate planning techniques. Cost segregation studies can be performed on virtually every type of building. There are, however, some cases where a cost segregation study may not yield enough benefit to the taxpayer or is simply discouraged under the current tax code. As each situation is unique, it is necessary to consult with accountants and cost segregation engineers.
It’s Not Too Late
A previous lack of awareness on cost segregation doesn’t translate to lost deductions. Recent tax regulations allow for taxpayers to correct their depreciation mistakes and to retrospectively “catch up” on any missed deductions provided by a cost segregation study. Although a cost segregation study can be performed at any time over the duration of ownership, it is always best to have one performed as soon as possible, preferably at the time of acquisition or at the completion of construction. This timing maximizes the possible deductions and increases cash flow sooner rather than later.
In today’s complex real estate market where making that next deal pencil out is getting tougher, cost segregation and its cash flow increasing capabilities can be a great way to strengthen your balance sheet and turn a once unprofitable deal into a worthy prospect.
CJ Aberin is a senior manager at KBKG, Inc., Cost Segregation Specialists in Pasadena.
Author: CJ Aberin | Publication: Real Estate Journal - Southern California