Slash Tax on Sale With This Little-Known Technique

Yes, cost segregation after the sale is a thing.

It’s not widely known, but it should be.

You may be aware that cost segregation can deliver significant tax savings to property owners if applied at various different points during the period of ownership, ranging from day 1 (completed construction or acquisition) to five, ten and sometimes even fifteen years after a property is put into service.

When cost segregation is applied to properties that have been owned for a year or more, it’s called a “lookback” study and is done, at least in part, to catch up on accelerated depreciation deductions not taken from the beginning of the period of ownership. The ultimate lookback study, then, is applying cost segregation in the year of sale, even after closing the transaction, but before the tax return for the year of sale has been filed.

While this is not done very often, it’s a smart option to consider if the property owner is not deferring gain via a tax deferred exchange. In this case there may be a sizable gain on sale, and the goal of applying cost segregation after the sale is to reduce the tax liability created by the gain.

To understand why this could be a good tax strategy, consider that applying cost segregation after the sale would create two opposing tax effects:

  1. It would increase depreciation deductions (the catch-up depreciation not taken during prior years), which would decrease ordinary income tax in the year of sale.
  2. It would increase taxes due on sale caused by recapture of additional depreciation deductions.

Under many circumstances, the increased depreciation deductions will greatly outweigh the increase in income taxes, providing the incentive to apply cost segregation after the sale.

Tax Arbitrage Opportunity

The tax liability due to recapture can be substantially lessened if part of it can be reclassified as long-term capital gain. This can happen by assigning fair market values to the assets in question, rather than their initial values. (At the extreme, one could use their tax bases at the time of sale, but the IRS probably would consider that too aggressive, thus the need to come up with fair market values of the assets).

The gain is then divided into depreciation recapture, taxed at the ordinary income tax rate, vs. long-term capital gain, which is taxed at a lower rate. Think of this as “tax arbitrage,” where the taxpayer is able to benefit from accelerated depreciation deductions at the ordinary income tax rate, and not all of those deductions are “recaptured” upon sale because some of them qualify as long-term capital gains and qualify for a lower tax rate. Since, in effect, not all of the depreciation deductions are recaptured, the amount of tax is lessened.

This idea is explained via a case study in this article by Harvey Berenson, CPA. In his example, the hypothetical owner of a $8 million 39-year real estate asset had a cost segregation study done after a five year holding period, and managed to save over $130,000 in income taxes using this technique. That savings would dwarf the cost of having a cost segregation study performed.

Is Cost Segregation After the Sale Right for You?

This application of cost segregation is complex and requires careful scrutiny by a qualified tax advisor with input from a cost segregation firm to help predict the likely outcome. Assumptions for the following key variables can be made in advance to predict whether tax savings can be achieved:

  • The dollar amounts of the initial cost basis of the property and the sales price (The higher the amounts, and the higher the difference between the amounts, the better);
  • The mix of short-term assets in the property (the more the better);
  • The seller’s tax bracket (the higher the better);
  • The length of time the property has been owned by the seller (the optimum would be somewhere between 5-15 years in most cases);
  • The value assigned to the land, real property, land improvements and personal property at time of sale, which together are used to determine the amount of long term capital gain on sale, an important mitigating factor against the effect of depreciation recapture).

WHAT TO DO

If you are selling, or have recently sold commercial real estate or apartments and never had a cost segregation study done, contact Jeff to discuss your situation and determine whether there’s still time to save a big chunk of taxes that otherwise would go to Uncle Sam.

Learn More:

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Unlocking Hidden Tax Benefits – Intro to Cost Seg

Introduction to Cost Segregation

WEBINAR: 4 Income Tax Crushers for Real Estate Investors

About the Author Jeff Glass

Jeff helps real estate owners increase their cash flow. He started his career as a Financial Analyst with the Irvine Company, and worked in various management/executive positions in the mortgage industry for many years. He's been a Cost Segregation consultant for several years and is considered one of the industry's top experts in TPRs. As Director of Business Development for Bedford Cost Segregation, Jeff helps his clients increase cash flow by accelerating their depreciation deductions, and by writing off assets that no longer need to be depreciated under recently changed tax rules. Jeff has a B.S. in Economics from Claremont McKenna College and an MBA with an emphasis in Finance from UC Berkeley.