Cost Segregation FAQ

[Julio Gonzalez]

Engineered cost segregation studies is an area in which many people have a lot of questions about. I thought it might be helpful to address some of the most frequently asked questions that I receive.

WHAT IS A COST SEGREGATION STUDY?

A cost segregation study is a strategic tax planning tool that separates the assets that have a shorter useful life and can be depreciated over 5, 7 and 15 years from the residential rental property or nonresidential real property that are depreciated over 27.5 and 39 years, respectively. By accelerating your depreciation schedules, you reduce your taxable income which in turn increases your operating cash flow. This also allows for property owners to more easily write-off assets that get damaged/destroyed as the value of these assets is determined as part of the study. You will receive a report as a result of the cost segregation study that supports the breakout between asset classes and new depreciation schedule in the event that you are audited by the IRS. Here’s an example of bonus depreciation.

WHAT IS THE COST OF A COST SEGREGATION STUDY?

If you’ve considered a cost seg study in the past but they were too expensive, times have changed and the fees have gone down significantly. The cost of a cost segregation study varies but typically ranges between $1,000-$15,000. The quality of the reports you receive also varies. Many cost segregation study professionals will offer you a free quote on the cost of the cost seg study specific to your property as well as the potential tax savings.

HOW LONG DOES A COST SEGREGATION STUDY TAKE?

Each property is different, however an engineered cost segregation study typically takes about 4-6 weeks to complete in order to ensure a quality cost segregation study.

HOW MUCH MONEY CAN A COST SEGREGATION STUDY SAVE ME?

Based upon the cost seg studies of my clients, a building will typically yield 25-30% of the total cost that can be segregated into personal property and land improvements. Here are the reclassification percentages.

HOW DO I CHOOSE A COST SEGREGATION STUDY PROFESSIONAL?

There are many cost segregation specialists to choose from, so it’s important to perform due diligence. Here are some important questions to ask when choosing a specialist.

• Does the firm have engineering licenses with the state authorities?
• How long has the firm been in business?
• What is their reputation with the IRS?
• Will they defend my report in an IRS audit?
• Do they include energy tax benefits within their study?
• Do they have insurance and property tax reduction reports in their study?
• Do they have the proper insurance and licenses?

WHAT CAN I EXPECT WITH A COST SEGREGATION STUDY?

This article walks through the steps in a cost segregation study.

WHAT INFORMATION DO I NEED TO PROVIDE IN A COST SEGREGATION STUDY?

The type of information needed depends on if the building is being constructed in the future or if the building already exists. Here’s a breakdown of some of the information you may need to provide for a cost segregation study.

WHAT IS CONSIDERED A QUALITY COST SEGREGATION STUDY?

The IRS defines a “quality” cost segregation study as “a study that is both accurate and well documented with regard to” 1) the classification of property into classes, 2) Explanation of rationale for the classification of the property and 3) substantiation of the cost basis of each asset and reconciliation of the total allocated costs to total actual costs. Additionally, the study should contain 13 principal elements.

WHAT ARE THE ELEMENTS INCLUDED IN A COST SEGREGATION STUDY REPORT?

You’ve decided to get a cost segregation study on your real estate property, but you aren’t sure how to determine which company to choose. It is crucial that you select a company that provides a “quality” cost segregation study as determined by the IRS. In a previous article, we covered the elements of a quality cost segregation study. Here we are going to talk about the elements of a quality cost segregation report.

CAN A COST SEGREGATION STUDY BE PERFORMED ON PROPERTY THAT I PURCHASED IN THE PAST?

Yes. Property owners can obtain a cost segregation look-back study on their current property to recalculate the depreciation for previous tax years based on their reclassified assets.

CAN I STILL DO A COST SEGREGATION STUDY IF MY CONDOMINIUM COMPLEX IS A SHORT-TERM VACATION RENTAL?

Yes. It’s important to note that short term rentals depreciate differently than long term rentals. Although a condominium is considered residential property, it's typically depreciated over 27.5 years. However, in the case of a short term rental, it would depreciate over 39 years depending on if 20% or more of the units in the entire building are considered transient (rented for 30 days or less).

WHAT ARE THE DIFFERENT METHODOLOGIES UTILIZED IN A COST SEGREGATION STUDY?

If you have hired a specialist to perform a cost segregation study of your real estate property, they will likely use one of the six most common methodologies recognized by the IRS. These methods include:

• Detailed Engineering Cost Approach
• Detailed Engineering Cost Estimate Approach
• Survey or Letter Approach
• Residual Estimation Approach
• Sampling or Modeling Approach
• Experience or “Rule of Thumb” Approach

For further details on the methodologies, refer here.

WHAT ARE THE BEST AND WORST PROPERTIES FOR COST SEGREGATION STUDIES?

A common misconception is that real estate properties under $1M have a smaller tax basis and therefore do not benefit from a cost segregation study due to the associated fees. However, properties ranging from $150k to $50M or more have benefited from cost segregation. This is due to bonus depreciation which allows taxpayers to deduct 100% of qualifying property costs in the first year, in addition to regular depreciation for new construction and improvement. The study could also identify the opportunity to capture additional benefits such as dispositions, and repair and maintenance expenditures. This would increase the benefit to where the fee would not be so outrageous that it would hinder the investment. However, with smaller investments, if bonus depreciation isn’t captured in the first year, a cost segregation study’s cost may outweigh the added benefit.

Additionally small tenant improvements could have similar benefits with bonus depreciation and new assets. Again, this is a conversation to have with your accountant to ensure the benefits would outweigh the costs.

Another misconception is that there is little value in a cost seg study for properties that do not have a lot of personal property in them or very little interior build out, such as industrial warehouses. However, these properties generally have a lot of land improvements that qualify as well as certain portions of electrical, mechanical and plumbing that can qualify. This allows for proper retirement of assets.

If a property has already been sold it may still be a good candidate for cost segregation as long as you sold the building and have not filed the tax return. This would allow you to maximize tax deductions at ordinary tax rates. Although the study may increase the gain, the gain may be taxed at a much lower rate making it a beneficial investment.

If a property is purchased with the intention to flip or own for a short period of time (less than 3 years), a cost segregation study may not be significant.

SHOULD I GET A COST SEGREGATION STUDY BEFORE OR AFTER REHABBING MY PROPERTY?

A cost segregation study should only need to be performed one time for each property and the annual depreciation calculated during the study using the detailed asset listing is relevant for as long as you own the property. However, there are instances where it may be beneficial to perform additional cost segregation studies.

You could perform a second cost segregation study after you’ve made large improvements to the property. Many improvements may qualify as Qualified Improvement Property (QIP) and can be written off immediately rather than being capitalized.

A question that investors ask a lot is if they should perform a cost segregation study before or after a rehab. If you purchased a property, it is recommended to perform a cost segregation study prior to improving / rehabbing the property as it is harder to document after the fact. The cost segregation study is used as your baseline. Once you’ve made the improvements to your property, you should have the receipts to justify the cost of all newly added items. With that information, your accountant can determine the amount of bonus depreciation your property is eligible for in relation to the new improvements. This would also allow you to utilize the Partial Asset Disposition deduction. This deduction is related to the loss on disposal of certain assets in your building such as replacing or removing existing components of the building.

Cost segregation studies can be a very beneficial tool for real estate investors. On average 20-40% of the property’s components can be depreciated over a shorter useful life which can result in a much lower tax bill and increased cash flow. So if you’ve already had a cost seg study performed and made significant improvements to your property, it could be beneficial to refresh the study. And if you haven’t performed a cost seg study before and intend on improving your property, I highly recommend doing so beforehand.

ARE THERE ADDITIONAL BENEFITS TO A COST SEGREGATION STUDY?

Some of the additional benefits include:

• Reduction in current tax liability
• Insurance savings
• Immediate increase in cash flow
• Minimization of recapture upon sale of the asset
• Identifying disposition expenses
• Identifying repair and maintenance expenses
• Energy cost savings
• Construction tax planning
• Preservation tax credits (historical and new market)
• Fixed asset review
• DEIRA Reports (reduces insurance premiums, benchmarking reports, energy audits and reserve studies)

What other questions do you have about cost segregation?