Cost Segregation

 Cost segregation can add tremendous acceleration to the depreciation deductions you claim on a building.  That puts money in your pocket.

 This can happen for you right now.  It can happen with a building you already own and have owned for some time, a building you plan to buy, or a renovation you are about to undertake.

 The purpose of this article is to expose you to “cost segregation,” which allows you to segregate a building into two components: personal property and land improvement.  When you apply the cost segregation strategy, you realize deductions faster.  Considering the time-value of money, you are adding dollars to your net worth.

 One study describes a $10 million building that segregated into 

• $2 million of equipment (20%)
• $2 million of land improvements (20%)
• $6 million of building (60%)

 Focus on the percentages: Had this building cost $100,000 rather than $10 million, the percentages could have been the same.  Consider that 20% of a building qualified for 5-years rather than 27.5- or 39-year depreciation, while another 20% qualified for 15-year depreciation.  The end result: a major difference in the timing of deductions.  The timing advantage can produce huge dollar benefits for you. 

Time-Value of Money

Tax law allows you to depreciate today’s buildings, land improvements, and equipment to zero.  Thus, the $10 million building described above has the ability to produce $10 million in depreciation.

 Cost segregation hurries up your deduction.  Assuming that your deductions produce tax benefits, you get the cash benefits earlier and put that cash to work sooner in your other investments.  To illustrate, say that 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 6% to put your tax refunds into today’s dollars, you would have

• $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 example, you are almost half a million dollars (223%) better off with the faster depreciation.  This is real money.  This is a huge difference.  This is what makes cost segregation so valuable. 

Will You Qualify for the Big Benefits?

 Cost segregation works for you when you will  

• benefit from the quicker deductions (i.e., the passive loss rules do not limit your deductions);
• benefit from the time-value of money (i.e., you will keep the building or be in the rental business long enough to benefit); and
• spend less on the cost segregation study than you realize in cash benefits.

 To benefit from cost segregation, you must realize the tax benefits of the quicker deductions.  You will not realize those benefits if the passive loss rules are limiting your real-estate loss deductions.

 In general, the passive loss rules destroy the loss deduction benefits of rental properties.  Before considering the cost segregation opportunity, you need to identify the effects of the passive loss rules on you.  You might be exempt from the rules or you might be subject. If the rules apply and limit your losses, then creating a bigger loss with cost segregation does you no good.

 Planning tip: Make qualifying to deduct your passive losses your number one priority in deciding whether you want to consider cost segregation.  If you can’t deduct your losses now, you will not benefit from the time-value of money, meaning that you will not benefit from cost segregation.

 The next consideration is the length of time you will keep the building.longer   The you keep the building, the greater the benefit from cost segregation.

 How many rental properties you own and how long you plan to own them are other factors to consider.  With planning, you can use a section 1031exchange not only to defer taxes, but also to carry the segregation benefits from one building to another.

 The final factor concerns the cost of the study.  Surprisingly, segregation studies can be very reasonable, especially in light of the benefits. 

Tax Advantages to Consider

 Cost segregation can produce an array of business advantages, including the following:

• Faster depreciation (allowing you to put the time-value of money to work for you)
• Section 179 expensing on qualifying personal property assets (usually in commercial buildings and home offices)
• Look-back depreciation on a building you already own with which you have never used cost segregation (you probably don’t want to look back more than five years or so)
• Bonus depreciation when your look-back period includes the bonus depreciation years of 2001-2004
• A one-time big adjustment that you might want to use when you have a particular tax problem (you claim all the previous years’ depreciation in one lump sum in the year of adjustment, using IRS Form 3115)
• Asset replacement identification for faster write-offs (As a side benefit, say you identify the cost of a roof in the study, then replace the roof in a later year. Now, you can write off the remaining cost of the original roof and start the depreciation on the replacement.  Without cost identification, you would not be in a position to write off the un-depreciated cost of the old roof.)
• Lower property taxes (depending on the taxes that apply to personal property and those that apply to real property)
• No user fee payable to the IRS to make this accounting change (Most people who make an accounting change have to pay the IRS a user fee of $2,500, although with gross income of less than $250,000, the fee is only $625.)
• Immediate write-off for the cost of the segregation study as a business (rental) expense in the year the study is done 

Tax Disadvantages to Consider

 The first disadvantage: the depreciation recapture tax on personal property can be greater than the recapture tax on real property.

 To the extent of gain, the depreciation claimed on personal property is recaptured as ordinary income at rates up to 35%.  The gain attributable to depreciation of real property is taxed at a maximum rate of 25%.  You might be looking at this difference when you sell. 

 Of course, the longer you wait before you sell, the less impact the depreciation recapture taxes will have.  Further, you may not be in the 35% rate bracket at the time you make the sale.

 Planning tip.  If you are subject to the alternative minimum tax (AMT),  use 150% declining balance depreciation of the personal property to avoid the 200% declining balance preference for AMT purposes.

 Again, you don’t want to use cost segregation if faster depreciation will not give you tax benefits because you suffer under the passive loss rules. 

Engaging a Professional

 To obtain the advantages of a cost segregation study, you must engage qualified professionals.  This is a wise expenditure when it puts real cash in your pockets. 

 In most cases, CPAs and engineers team up to provide cost segregation services.  The American Society of Cost Segregation Professionals is a good place to look for a professional, although you should first check with your tax advisor for his or her recommendation.

 The cost segregation professional puts together all the paperwork you need to prove the segregation.  In general, audit work papers, experience, and credentials will back the package you receive.

 If you use a professional and submit the paperwork to the IRS properly, you will suffer no increased risk of an IRS audit because of the cost segregation study.  In fact, a properly submitted cost segregation study might actually lower your risk of an audit, because you’re showing the IRS that you know the rules and have done your due diligence to comply.   

Timing Your Look-Back Cost Segregation Study

 When you do your look-back cost segregation study, you submit the cost segregation depreciation changes under the rules for an automatic change in accounting, which allow you to do this for free and without IRS approval (the approval is automatic).  But the IRS does not allow automatic approval whenever you get the urge.  You get automatic approval once; after that, you have to wait five years or go through the IRS approval process. 

Recommendation.  Do the cost segregation on all your properties at once.  If you are going to change the depreciation in your business office, rental property, and home office, do so in a single submission. 

An Unusual Opportunity

 You might consider a cost segregation study when you receive an inheritance.  Say, for example, that your spouse dies and the property becomes yours with a stepped-up basis.  You can use cost segregation on this new stepped-up basis to allocate basis to equipment and land improvements.

 You might mention to your heirs that cost segregation of the property can be a big benefit when they inherit the property after you die. 

Summary

 Cost segregation deserves your attention.  It can create benefits with buildings you already own and buildings you will buy. 

 The benefits are easy to quantify.  Cost segregation is one of the few investments you can make that absolutely guarantees your rate of return.  In fact, you know just about everything that will happen when you give the go-ahead for a cost segregation study.

Before doing the study, make sure you are on top of passive loss rules.  If the passive loss rules deny your annual real-estate losses, a cost segregation study will do you no good.

 Also, consider the AMT in choosing the depreciation method for your cost-segregated personal property.

 Once you have all this in order, do the cost segregation study.  You are putting the time-value of money to work for you.