Five Misconceptions of Cost Segregation
Cost Segregation is an extremely valuable tax planning tool that provides significant savings to real estate owners by increasing cash flows through accelerating depreciation deductions. As with anything in the “tax world”, there are variables that can affect the amount of savings a cost segregation study can produce, and additional complexity that can come from the real estate owner’s individual tax situation. Widespread misconceptions around these variables often lead taxpayers to leave a large amount of money on the table. Below are five common cost segregation misconceptions that our experts regularly observe:
- Cost Segregation is only a timing difference
While it is true that a building will eventually be fully depreciated in 27.5 or 39-years, cost segregation studies reclassify property into asset classes with shorter recovery periods such as 5, 7, and 15-year lives. Doing so takes advantage of the time value of money by generating large deductions early in the asset’s life. Deductions that are taken today will be much more valuable than deductions taken down the road. With inflation on the rise at a rapid pace, this timing difference is more valuable than ever. Real estate owners can take the savings a cost segregation study produces in the current year and reinvest it into their business, creating a higher return than the tax savings would from a depreciation deduction if the property was left in the former 27.5 or 39-year recovery period.
- Cost Segregation is not an option if property was placed into service in a prior year
Cost segregation studies can be performed on properties placed into service dating back to 1986. While it may not always make sense, an expert can help determine the magnitude of savings a study can produce on older properties. Often, real estate owners are deterred because they believe they will have to amend a return, which is not the case. Owners need to file a Form 3115 with their current year tax return, which will include a 481(a) “catch-up” depreciation adjustment. The “catch-up” depreciation amount is the difference between what should have been depreciated in prior years with the correct asset classifications and the amount that was depreciated in prior years. The taxpayer takes the full 481(a) deduction in the current tax year. An experienced cost segregation partner can help your accountant prepare the proper items on the return correctly as well as calculate the 481(a) adjustment that is included in the Form 3115.
- Cost segregation studies increase the chance of an audit
Taxpayers are often surprised to hear that the IRS supports cost segregation studies as long as they are completed within published guidelines. These guidelines are mentioned in the IRS Field Audit Techniques Guide (ATG), which details several elements for a quality study and report. The ATG covers guidance related to cost segregation including court cases specific to cost segregation, issue specific guidance, and industry specific guidance. Experienced partners can properly interpret the tax law surrounding cost segregation and build projects that withstand IRS scrutiny.
- Small properties with low tax basis do not make sense for cost segregation
With 100% bonus depreciation in effect through the end of 2022, real estate owners with small properties can realize significant savings from a cost segregation study. Properties with basis of a few hundred thousand can work depending on the property and project. For example, consider a taxpayer in the 35% tax bracket who completes a $350,000 renovation of a medical office space. This renovation includes replacing partitions, flooring, plumbing, electrical, HVAC, façade repairs, and new cabinetry. As a result of a study, there is a 45% reclassification into 15-year Qualified Improvement Property and 5-year personal property which are all eligible for 100% bonus depreciation. This study results in a first year accelerated depreciation deduction of $157,500 and a first-year increased cash flow of $55,125.
- Cost segregation will cost me more money down the road when I sell due to recapture
Cost segregation studies can create permanent tax savings for a property owner even if the owner plans to sell the property down the road; however, it is typically recommended that a property be held for at least three to five years after completing a study to realize benefits. While the holding period depends on each unique situation, these guidelines are a good starting point for planning. Although there might be some increased tax due at the time of sale due to recapture, this should not scare away property owners from completing a cost segregation study. The increased cash flow from the accelerated depreciation deductions offset ordinary income often outweigh the increased tax from recapture. This is because recapture is limited to the gain on the sale of the property and there is a reduction of value for the personal property from the time the property starts its depreciation to the time it is sold.
While there are others, these are the five most common misconceptions our team at McGuire Sponsel encounters when discussing cost segregation opportunities with our clients and partners. No one likes to leave money on the table when it comes to taxes, so consulting with an expert is the best path to ensure all opportunities for savings are identified. To discuss with our team further, contact us.