Frequently Asked Questions

Cost Segregation

What is cost segregation and why would it be used?

If you own commercial real estate or apartments, you are probably concerned about getting the most yield from your investment. Accelerating your depreciation deductions is a frequently overlooked strategy for boosting your return without increasing risk.

Cost segregation is the IRS-accepted method of taking accelerated depreciation on commercial and multifamily real estate. It is a tax strategy often overlooked by property owners. Through cost segregation, you can shift a good portion of the usual straight-line schedule of depreciation deductions (39 years for commercial property, and 27.5 years for apartments) to earlier years during your period of ownership. This way, you can reduce your taxable income in those years and increase your cash flow. Real esta
te owners have been using cost segregation since it first became recognized by the IRS in 1997.

How much tax benefit does cost segregation provide?

The value of cost-segregating your property could range between 4% and 8% of the initial cost basis of your property, net of land cost. That is, for each $1 million in depreciable cost, you could be looking at $40,000 to $80,000 in additional after-tax cash flow if you apply cost segregation.

How much does cost segregation cost?

The value of deferred income taxes from cost segregation is usually 10 or more times the after-tax cost of having a cost segregation study performed, and often a higher multiple than that.

Why not just use the usual depreciation method?

Not segregating costs for depreciation purposes is like providing an interest-free long-term loan to the government. By applying cost segregation, a property owner can pay only the amount of income tax required, rather than an excessive amount. If a building owner is depreciating their building on a 39 year or 27.5-year straight line basis, then they are depreciating some short-term assets over an excessively long time. Nearly every commercial or multi-family residential building includes a significant number of assets that qualify for accelerated depreciation, typically anywhere between 15% and 40% of the original cost basis. If these assets are depreciated over an unnecessarily long time, rather than the actual time periods allowed under the tax law, the tax payer is paying more tax, earlier, than they are legally required to pay. That’s like loaning money to the government, at no interest.

Is cost segregation only for large, high-value buildings like office towers and shopping centers?

No. Cost segregation is not just for big, high-value buildings. The tax benefits of cost segregation can vastly outweigh the costs, even for small buildings. When cost segregation was a new phenomenon, the cost of hiring the engineers to classify building components was high, limiting its application to major properties. Today’s cost segregation providers have developed and refined efficient methods of performing IRS-compliant studies so that the cost of a study is modest. Consequently, even buildings with as little as $1,000,000 in original depreciable cost basis are suitable candidates for cost segregation.

If I didn’t apply cost segregation when I purchased or built my building, can I still use it?

Yes. Cost segregation is not just for newly acquired buildings. Many years ago, the IRS agreed that tax payers are permitted to obtain the benefit in the current tax year of accelerated depreciation expense they could have taken in past years, but was not. In effect, the IRS offers a catch-up provision in their depreciation rules, so that a cost segregation study can be applied today to a building purchased as long ago as 1987. As a practical matter, buildings purchased at any time within the past one to fifteen years are good candidates to benefit from a cost segregation study, because some portion of the five-, seven- and fifteen-year components of their buildings can be written off sooner than if they remain on a 39 year or 27.5-year depreciation schedule.

Do I have to amend prior year tax returns if I apply cost segregation retroactively?

No. It is not necessary to amend past tax returns to retroactively apply cost segregation. In fact, the IRS does not allow amending tax returns for this purpose. Instead, a far easier method is required. The IRS allows tax payers to “catch up” on accelerated depreciation not claimed in past years by filing for a Request for Change in Accounting Method using IRS Form 3115. Such requests are granted automatically by the IRS. Once filed, the tax payer can claim in the current tax year all the accumulated depreciation that could have been taken in past years, which can result in a large one-time tax benefit in the year that the catch-up depreciation expense is taken.

What types of property can be cost segregated?

The tax savings offered by cost segregation can be obtained from nearly any type of building. The most commonly seen examples are office buildings, retail, industrial, restaurants, auto dealerships, apartments and hotels. We also see many other types of properties having cost segregation studies performed on them, including car washes, casinos, golf courses, wineries, marinas, health spas, hospitals, parking structures, self-storage facilities, truck stops and many more. Any type of depreciable real estate is capable of being cost segregated for income tax purposes.

Are there any requirements of the property owner to be able to use cost segregation to reduce income taxes?

Most building owners will benefit from cost segregation, if they are earning income and paying income taxes. There are three tests applied by the IRS that determine whether a tax payer is eligible to defer taxes via cost segregation:

  1. Is the building occupied by its owner? If not,
  2. Is the owner a real estate professional who spends 750 hours a year or more in real estate activities (there are various ways to meet this requirement; or
  3. Does the taxpayer have sufficient passive income to offset passive losses created by the increase in depreciation expense enabled through cost segregation? (There are various ways to meet this requirement.)
    Note that in the third instance, it may be possible, within certain limits, for a building owner to adjust upward the rent charged on real estate owned by an amount that offsets what would otherwise be a passive loss resulting from increased depreciation expense.

If I sell my building won’t I have to give back the cost segregation tax benefits via “recapture?”

Recapture does not nullify the advantages of cost segregation. There is some complexity to this topic, but a simple explanation is that when cost segregation is applied, there are three possible outcomes regarding recapture when the owner disposes of the building:

  1. If the building is exchanged rather then sold, all taxes are deferred, so recapture is a non-issue.
  2. If a sale occurs, with diminished value, there will be some recapture.
  3. If a sale occurs, with increased value (the most conservative scenario), then all the accelerated depreciation obtained via cost segregation may be subject to recapture. In the worst case, all accelerated depreciation is recaptured so the owner has had free use of the money not paid in taxes from the time accelerated depreciation commenced until time of sale. As a practical matter, some of the assets sold will have declined in value, and a purchase allocation can be made which will reduce the gain on sale and partially offset the effect of depreciation recapture. Cost segregation should never be avoided solely because of recapture concerns.

Does cost segregation increase the chances of being audited by the IRS?

Cost segregation does not increase the chances of being audited. The IRS has for many years recognized the legitimacy of cost segregation as a means of more accurately accounting for building costs. This fact is reflected in the IRS Audit Techniques guide, which provides over 100 pages defining the proper methodology to be followed for a cost segregation study.

When a cost segregation study involves a building owned for a year or more (i.e., a “lookback study,”) rather than amending past tax returns, the IRS directs tax payers to file Form 3115, Change in Accounting Method, to apply the results of a cost segregation study. In most cases, whenever a change in accounting method is sought, the IRS will review the request. In the case of cost segregation, however, the IRS automatically accepts the request for a change in accounting method without review.

How do cost segregation studies relate to the new IRS Tangible Property Regulations?

Cost segregation helps property owners and their tax professionals bring depreciation schedules into compliance with the new IRS tangible property rules. Under certain circumstances the new rules provide a strong incentive for building owners to have a cost segregation study completed, for owners to have the option to write off rather than capitalize certain building-related expenses. The cost segregation methodology employs what the IRS calls a “certain method” that they will always accept for quantifying the value of the building systems comprising a building. This approach enables tax professionals to correctly apply future tests for determining whether expenditures related to a building can be expensed rather than capitalized.

What if I remove assets from my cost-segregated building?

Cost segregation can be applied to valuing abandoned building assets so their remaining book value can be expensed. Building renovations usually generate a significant amount of demolition debris. Under the new IRS Tangible Property Regulations, if the remaining tax cost of abandoned building components can be accurately separated from the overall tax cost of the building then the remaining cost basis of the individual item that has been removed can be written off in the current tax year. The engineering-based cost segregation method is usually the soundest approach to arriving at the necessary figures to make this type of tax deduction possible.