Cost Segregation Studies

[Jeremy Bottlinger]

A cost segregation (seg) study is a detailed analysis of the components of a building so that the separate components can be separated and classified into shorter depreciation lives. By performing this study, building owners can reap a number of benefits that can positively impact their cash flow and overall financial position. However, a cost seg study is not always a slam-dunk and should be discussed with your CPA to determine if it is appropriate for you.

One of the primary benefits of a cost seg study is the acceleration of depreciation expense. Under normal tax rules, buildings must be depreciated over 27.5 or 39 years - residential rentals are 27.5 while commercial buildings are 39 years. However, a cost seg study allows certain components of the building, such as electrical and plumbing systems, to be classified as personal property, which can be depreciated over shorter lives of 5, 7, or 15 years. This means that the owner can claim a larger portion of the building's cost as a tax deduction in the early years of ownership, rather than spreading it out over 27.5 or 39 years.

Another benefit of a cost seg study is the time value of money. The time value of money principle states that a dollar today is worth more than a dollar in the future. By accelerating the depreciation expense, the building owner can take advantage of the present value of money, rather than waiting 27.5 or 39 years to claim the full value of the building as a tax deduction. This can have a significant positive impact on cash flow and overall financial position which, could, allow you as a real estate investor the ability to acquire additional properties. To illustrate the time value of money in relation to accelerated depreciation in real estate, let's consider a building that has a total cost of $1,000,000. Here is how much depreciation could be claimed each year:

• Over a 5-year period, the building owner would be able to claim $200,000 annually as a tax deduction.
• Over a 7-year period, the building owner would be able to claim $142,857 annually as a tax deduction.
• Over a 15-year period, the building owner would be able to claim $94,684 annually as a tax deduction.
• Over a 27.5-year period, the building owner would be able to claim $36,363 annually as a tax deduction.
• Over a 39-year period, the building owner would be able to claim $25,000 annually as a tax deduction.

NOTE: The above numbers present a simple illustration based upon all of the business components being classified within one time period. In reality, the building will have business components within multiple depreciation periods.

A cost seg study can be performed at any point, whether the building was purchased, constructed, or has been in use for some time. However, if the building is currently under construction or has recently been completed, it is more efficient to perform the study at this time. This is because the schedule of values from the contract file can be used, which makes the process more accurate and cost-effective.

The process of performing a cost seg study typically begins with a walk-through of the building, during which the cost segregation consultant will identify and document all of the building's components, including electrical, plumbing, HVAC, and other systems. They will also identify the costs associated with each of these components and the costs of the building's overall construction. The consultant will then use this information to classify the various components of the building as either real property or personal property, depending on their expected useful lives.

Once the classification process is complete, the consultant will provide the building owner with a detailed report that includes the costs of each component, as well as the accelerated depreciation schedule that can be used for tax purposes. The building owner can then work with their CPA to file the necessary tax forms and claim the additional depreciation. The CPA will report the results of the study by completing Section 481(a) of the Form 3115 to report the additional depreciation being claimed. It is important to work with a CPA when choosing a cost segregation study consultant as a CPA can ask pertinent questions, ensure the final report is of high quality, and help you determine if the ROI of the cost of the cost seg study makes sense for your building.

A few things you should be aware of when considering a cost seg study (based upon my research or seeing ‘scary’ things in practice):

• CPAs CANNOT do these alone
  • o An engineer must be involved OR, in my opinion, an other qualified professional that understands construction and a schedule of values like, maybe, a contractor that:
    • Renovates/builds residential buildings
  • Constructs/retrofits multi-family units
  • Constructs/retrofits commercial buildings
  • An actual cost seg study must be done to break-out components of a building. You can’t just alter your depreciation schedule and ‘randomly’ assign values to various different components of a building structure
  • Evaluate the person/consulting firm performing the cost seg study:
    • o Ask for an example of their final report
  • o Ask for a fee quote
    • Get multiple bids
  • o Compare the example of the final report to the fee quote
    • In my opinion, you NEVER go with the lowest bidder because, as with everything in this world, you get what you pay for.
  • o Evaluate your circumstances with your CPA to determine if a cost segregation study is even worth it for you:
    • If you are already generating passive losses which are being carried-forward THEN there is no reason to get a cost seg study because you are just going to increase the passive losses that are going to be carried forward.
  • Evaluate the fee quote compared to the tax savings generated by the cost seg study. An experienced CPA can estimate/evaluate the potential savings before an actual cost seg study is performed
  • Ask questions – lots of them. If anyone, at any time, no matter where, or no matter what, or who you are with makes you feel like asking questions is a bad thing then avoid working with that person.
    • o Sorry – the above was a little reference to The Office
      • “Don't ever, for any reason, do anything, to anyone, for any reason, ever, no matter what, no matter where, or who, or who you are with, or where you are going, or where you've been, ever, for any reason whatsoever.” Michael Scott

In summary, a cost seg study is a valuable tool for building owners, as it can accelerate depreciation expense, improve cash flow, and increase overall financial position. The process of performing the study is relatively straightforward, and the results can be used to file the necessary tax forms and claim additional depreciation. Building owners should work with a knowledgeable CPA to help you determine if a cost seg study is worth it for your situation.

@Andrew McGuire