Steve Minick, Property Controller, shares his insight as to the possibility for cost benefits from using cost segregation.
Anyone who has constructed, purchased, expanded, or remodeled any kind of real estate since 1987 with an invested value of more than $1.0M is eligible to utilize to accelerate the depreciation on the building. A cost segregation (cost seg) study is part of a tax deferral technique that separates a building into its component pieces for depreciation purposes. With a cost seg study, you can depreciate component items (qualifying property) over 5-, 7-, or 15-year periods, versus the 39 years for commercial properties and 27.5 years for residential properties. Additionally, beginning in 2017 the Tax Cuts and Jobs Act (TCJA) sweetened the deal allowing for a 100% deduction of the qualifying property acquired and placed in service after September 27, 2017. The 100% allowance will begin to phase out by 20% per year beginning in 2023 and will expire December 31, 2026. Here, we take an expedited review covering the basics when diving into the potential tax benefits of cost segregation.
What is cost segregation?
Cost segregation is a strategic tax planning tool that allows you to accelerate depreciation deductions into the early years of ownership. Since the main building component has a class life of 27.5 or 39 years, there could be substantial depreciation in year one by reallocating the building’s components (HVAC, electrical, water, etc.) to a 5- or 15-year lifespan. As noted above, under the TCJA a 100% deduction is currently available on the identified components. Deductions related to warehouse industrial range in the 10-20% of total costs with apartment building ranging from 20-35%.
Why should you do it?
Faster depreciation means more cash available upfront to utilize for other means. The cost segregation study separates the entirety of the property into its component parts in order to realize the building as a sum of its parts. Using a standard straight-line schedule, the whole of the building structure would usually depreciate over a 27- or 39-year lifespan period. There are many things, however, in real estate that will depreciate more rapidly than this schedule. These things include subcomponents such as carpeting, cabinets, parking lots, lighting fixtures, landscaping, some electrical wiring, plumbing, and many other components that will deteriorate over the life of the property. Breaking down the value of deteriorations for the life of each of these subcomponents allows the opportunity to defer taxes which will, in turn, increase your near-term cash flow.
When should you do it?
It’s best to do this within the first year of purchase to reap the maximum benefits and before any construction rehab, but IRS rules allow you to do so any time after the property is purchased. Performing the study before renovations occur allows the engineers to establish a baseline for the value in original purchase price. Subsequent additions or improvements can then be placed into the appropriate classification for depreciation purposes.
How do you do it?
A qualified and licensed engineer and team of accountants is hired to inspect the condition of the property, estimate the value of all the components within it, and assess proper classifications for tax purposes. They will analyze the detail and condition of the building’s depreciating subcomponents (such as the window or HVAC units, lighting fixtures, etc.) in order to allocate their value and condition. The report provided will be utilized by the property’s tax preparer in filing the return and maximizing potential deductions.
Can I utilize the deductions?
Most real estate investments are held in tax pass through entities (generally an LLC or partnership). This allows the individual components of the taxes to be allocated directly to the partners. The pass-through rules are very complicated and depend on the individual taxable circumstances of the partner. The ability to utilize these deductions needs to be carefully analyzed by the partner’s tax preparer.
If you are interested in more details on cost segregation, check out Engineered Tax Services discussion at Cost Segregation Study | See If You Qualify (engineeredtaxservices.com).
Steve Minick
Steve leads the property accounting team, which provides financial accounting and reporting for all of Westmount’s real estate investment properties. He has more than 30 years of accounting experience and has served as a Chief Financial Officer/Controller for various real estate development, investment, and management companies. He is a Certified Public Accountant in Texas.
To learn more about Westmount Realty Capital or for additional information, contact us at info@westmountrc.com or find us at https://westmountrc.com/.
This article, and Westmount Realty Capital blogs in general, is intended for informational and educational purposes only, and does not constitute a solicitation or offer by Westmount Realty Capital, LLC to buy or sell any securities, futures, options, foreign exchange or other financial instrument or to provide any investment advice or service. Westmount is not your advisor or agent. Please consult your own experts for advice in these areas. Although Westmount provides information it believes to be accurate, Westmount makes no representations or warranties about the accuracy or completeness of the information contained on this article.
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