A skeptical judge wrote during a 2012 memorandum opinion concerning a court case between a real estate business owner and the IRS, “We are tempted to say this is why Amerisouth throws in everything but the kitchen sink to support its argument – except it actually throws in a few hundred kitchen sinks, urging us to classify them as “special plumbing,” depreciable over a much shorter period than apartment buildings.” And so begins my attempt to explain the wonderful world of cost segregation. I promise it isn’t as bad as it sounds in this court case.
Cost segregation is a great tax planning tool that, documented properly, can help a taxpayer accelerate depreciation expense and reduce their tax liability. A caution is that cost segregation may cause future cash flow issues if not planned for properly. But I may be putting the cart before the horse by not defining cost segregation, what it means and whether it applies to you as a real estate investor.
Acquisition and Development Costs Get Capitalized
Owners of rental real estate are required to capitalize upon acquisition or development all costs associated with land and buildings. They can depreciate those costs allocable to the building (27.5 years for residential buildings; 39 years for commercial buildings). If such costs could be broken out into specific components such as furniture, equipment, cabinets, floor coverings, land improvements, or paving (to name a few), then the depreciable life could be lowered to 5, 7 or 15 years.
Generally, the shorter the life, the quicker the asset is expensed, which further reduces an owner’s taxable income. The lower the taxable income, the lower the tax liability. Sometimes in an acquisition or development it is impossible to capture costs associated with the shorter asset lives because all costs are included in a larger lump sum on an invoice or settlement statement. The company accountant may just allocate a portion to land and capitalize the remaining amount as one item – “Building” and begin depreciating this over the 27.5- or 39-year life.
Cost Segregation Defined
A cost segregation study is an engineering analysis performed by a qualified company that details a study on the cost of the acquisition or development of a property and provides a very detailed report of assets broken out into shorter and longer lives.
The process begins with a representative of a cost segregation company contacting the owner. It’s also possible to have a “lookback” cost segregation study performed on a building you have already placed in service in a prior year.
A discussion will proceed where the representative will ask a series of questions to see if a cost segregation would be advisable. The company owner will provide information to the representative and will receive a ballpark idea of what potential savings would be available. If the owner decides to engage with the cost segregation company a request of AIA documents (all invoices, including settlement statement, received that includes building and land costs) is made so that the company can begin prep work on the actual cost segregation. In most cases an engineer will schedule an onsite meeting with the owner so that he can personally tour the building.
This process will help the cost segregation company to identify and transfer some costs into shorter life assets. In addition, the engineer may be able to identify longer life structural components used mostly by shorter life assets, such as electrical outlets used only by refrigerators, and determine a percentage of those structural components that can be assigned a shorter life.
It is worth mentioning that not all cost segregations have to be performed by a qualified company. Your tax advisor may be able to assist you with reviewing your asset schedule and inquiring about certain assets to see if they can be broken into smaller components.
Generally, a qualified cost segregation company is used on a more expensive property when the costs are not black and white. The cost segregation company can allocate costs based on experience and using data from prior cost segregations they’ve performed.
You won’t find any Internal Revenue Code section that defines cost segregation. There is a 121-page audit technique guide written for IRS agents to use when auditing a cost segregation. It specifically mentions that the information provided in the guide cannot be used or taken as law or authoritative definition of a given topic. Choose a reputable firm with a good history of cost segregation preparation in the event your position is challenged by the IRS.
Cost Savings Example
The following table represents a recent cost segregation for a multi-family apartment building:
|Purchase price||$ 4.6 million|
|Land value||$ 700k|
|Total depreciable assets||$ 3.9 million|
|Year 1 depreciation expense without cost segregation (September placed in service date)||$ 38k|
|Assets identified by cost segregation study with 5, 7 or 15-year life||$ 1.05 million||(all eligible for 100% bonus depreciation)|
|Depreciation expense with cost segregation||$ 1.08 million|
|Tax savings on depreciation expense WITHOUT cost segregation (assumed 37% tax bracket)||$ 14k||approximate|
|Tax savings on depreciation expense WITH cost segregation (assumed 37% tax bracket)||$ 400k||approximate|
I’ve highlighted the tax savings with and without having a cost segregation study performed. Please note that the partners in this partnership were all real estate professionals and materially participated in the business.
The engineer from the cost segregation company was able to identify over $1 million in assets with shorter lives. This was even more advantageous because the assets were eligible for 100% bonus depreciation.
I’ve discussed cost segregation studies with clients in the past, and one common worry is the amount they will pay to have the study performed. My advice to them is that it costs nothing to have a conversation with the cost segregation company. Generally, the cost segregation company will provide them with an estimation of benefits report listing the possible accelerated depreciation expense and share with the taxpayer at no cost. The taxpayer can then consult with their tax advisor who can determine the projected tax savings before choosing to have the cost segregation performed.
Any Disadvantages to Cost Segregation?
As I noted in the opening, there are a few disadvantages to a cost segregation, but they wouldn’t stop me from at least discussing the option. I highly recommend you consult with your tax advisor prior to accepting an engagement with a cost segregation company.
There have been court cases in the past that found the taxpayer having their depreciation expense disallowed because of taking an aggressive position on the return using a cost segregation study. The rules of depreciation are often murky and without sufficient backup to your position, you may find a red flag has been raised on your return prompting an inquiry from the IRS.
I’ve also heard stories of taxpayers engaging in a cost segregation study only to wind up paying more for the study than they ultimately got in tax savings. For example, if you are a passive investor you may not get full advantage of the tax savings if you end up with a taxable loss and not able to net the loss with any passive income. You’ll be able to accelerate depreciation, but any resulting loss will get suspended indefinitely until the year you have passive income or dispose of the property.
Another thought is how accelerating depreciation can affect cash flow. If your company does a good job of budgeting and managing cash flow, this will not be a problem. But if you are used to getting a steady stream of depreciation expense each year and all of a sudden accelerate most of this into the current year, you may not be prepared for the additional tax liability you could face in future years.
The current tax year may save you a lot in taxes, but your larger tax liability in future years will require more cash budgeted to pay your liability. This is avoided with yearly (and even quarterly) planning with your tax advisor with a focus on tax liability projections.
Cost segregation studies are a great tax planning tool to help you reduce taxes. So, take a walk through your apartment complex and think of all the shorter life assets a cost segregation could uncover, just maybe not kitchen sinks, then give your tax advisor (or me) a call. You’ll be glad you did.