How Cost Segregation Studies Work to Save Big on Taxes

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Getting a cost segregation study is one strategy real estate investors can use to reduce their taxes. By combining this strategy with the Real Estate Profession Status (REPS) or the STR Loophole, investors can take the natural depreciation of their property and generate a loss. This loss can then be used to offset non-passive income (e.g. W-2, 1099, etc) income and reduce taxes. When researching cost segregation studies, investors should know about the different types of cost segregation studies and the effect this can have in an audit and on price. In this article Digb will examine Cost Segregation studies and give you the information you need to determine the best option for you.  

What is a cost segregation study

A cost segregation study is a report that breaks the property into smaller pieces to reflect the useful life different parts of the property have, and how long it will take them to wear out. This report allows rental owners to shift their property from a single traditional depreciation schedules, to multiple depreciation schedules, and maximize depreciation, or elect bonus depreciation. 

Most investors will be familiar with the idea that a brand-new car will lose value as soon as it is driven off the lot. This is due to the concept of depreciation. Although the vehicle looks brand new, there has been wear and tear on the vehicle that results in lost value (or a loss). Like a brand-new car, new construction will immediately begin to depreciate after the build has been completed. 

By default, the IRS uses a straight-line depreciation schedule. Here the property will depreciate the same amount each year for 27.5 (long-term rental) or 39 years (short-term, commercial). However, most real estate investors would agree that the entire rental property will not wear out evenly over a 27.5 (or 39) years. For example, the fridge will likely need to be replaced a couple of times before the roof. As a result, the IRS would agree that a cost segregation study makes sense to shift from a single straight line depreciation schedule to multiple depreciations schedules depending on the period of time (a.k.a. Useful life) things are expected to take to wear out.

Note: You cannot depreciate the cost of land because land does not wear out, become obsolete, or get used up. The cost of land generally includes the cost of clearing, grading, planting, and landscaping. You can spend more time reviewing the details in IRS Pub 946, How To Depreciate Property.

How it works 

When performing a cost segregation study, the first thing that will happen is the value of the land will be subtracted from the basis of the property. The remaining value will contain the items that can be depreciated. A cost segregation study will then begin grouping these items into useful lifespans (a.k.a. the period of time it takes for things to wear out). With the new depreciation schedules in place, the owner now can take the accelerated depreciation. 

Are there different ways to do a cost segregation study? 

The IRS cost segregation audit guide has outlined five individual ways to perform a cost segregation study these include: 

1.     Detailed Engineering Approach from Actual Cost Records 

2.     Detailed Engineering Cost Estimate Approach 

3.     Survey or Letter Approach 

4.     Residual Estimate Approach 

5.     Sampling or Modeling Approach 

6.     “Rule of Thumb” Approach 

In an audit, the IRS will give more credibility to a study that was performed in person by a qualified individual. This is because these studies tend to be more detailed and specific to that property. These studies tend to be conducted by an engineer or individual experienced in construction. While these studies tend to result in a higher amount of depreciation, they are also more expensive and can take significantly longer than a modeling approach.

The modeling approach tends to be more conservative than an in-person study. This is because it uses statistics to estimate depreciation based on several factors. As a result, an investor can expect their study to show at least 5% less in depreciation than a detailed engineering approach. If an investor receives a cost segregation study based off modeling, they may be able to complete the entire process in as little as 15 minutes whereas a detailed approach can take as much as eight weeks. Many of the modeling options offer audit protection and will still stand up in court. However, the IRS is not going to look as favorably on a remote study as one that was done in person. Investors should weigh the pros and cons of the different types of studies and understanding the differences before selecting the option that is best for them. 

The rule of thumb approach is the lowest level of cost segregation study on the list provided by the IRS. This is because it is not based on records or documentation but instead off the experience of the inspector. While it is still possible for a Rule of Thumb study to pass an IRS Audit, it is also more likely this study is less detailed than the others, resulting in missed depreciation and savings. 

What is included in a quality cost segregation study

The IRS has stated there is no standard format for conducting a cost segregation report. As a result, there is no requirement for length or level of complexity. However, studies should always classify assets into property classes, explain the rationale for the classification, and substantiate the cost basis of each asset and reconcile total allocated costs to total actual costs. The study will also contain several characteristics which are listed below:

The IRS’s audit guide includes thirteen characteristics of a cost segregation study

1.     Preparation by An Individual with Expertise and Experience 

2.     Detailed description of methodology 

3.     Use of appropriate documentation 

4.     Interviews conducted with appropriate parties 

5.     Use of common nomenclature 

6.     Use of standard numbering system 

7.     Explanation of the legal analysis 

8.     Determination of unit costs and engineering takeoffs 

9.     Organization of assets into lists or groups 

10.  Reconciliation of total allocated costs to total actual costs 

11.  Explanation of the treatment of indirect costs 

12.  Identification and listing of 1245 Property 

13.  Consideration of related aspects (e.g. IRC 263A, change in accounting methods and sampling techniques. 

Investors should file with confidence if their cost segregation study meets the standard above. However, investors should also be aware of the drawbacks associated with cost segregation studies. 

Depreciation recapture and other considerations 

Before an investor gets a cost segregation study, they should be aware of depreciation recapture and ensure they have a sound long term tax strategy. If the investor sells the property that has been depreciated, they may need to pay back 25% of the total depreciation they have taken. While there are ways to avoid the recapture, it is always best to have a strong financial plan before taking depreciation. 

Similarly, once the property has been depreciated it can be difficult regenerate these losses. Therefore, the same amount of depreciation may not be available year after year. Investors should make sure they have both long and short term planning in place to optimize their tax savings and not become short sided. 

There are tax strategies to avoid depreciation recapture. Consult a Real Estate CPA to learn more.

This article is provided for illustrative purposes only; it does not provide personalized tax, legal, financial, or other professional advice. Your situation may be different; consult a professional for information concerning your individual tax, financial, or legal situation before taking any action.