Common Concerns of Cost Segregation

[Julio Gonzalez]

Cost Segregation has been a hot topic the past couple of years. But what is it exactly?

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.

What are some of the most common concerns with utilizing a cost segregation study?

• Depreciation Recapture: When a property is sold, any depreciation that was accelerated as a result of a cost segregation study may be recaptured by the IRS. The amount that is recaptured is subject to the taxpayer’s regular income tax rate which is typically higher than the capital gains tax rate. Thus, this could possibly lead to a higher tax liability when the property is sold. However, this is a key area of concern that should be considered during tax planning and if a property is held for a long period of time (greater than 2 years), the benefits from the cost segregation study can outweigh the potential depreciation recapture tax liability.
• Audit Risk: The IRS has very specific guidelines for conducting a cost segregation study and any divergence from these guidelines could trigger an audit. The prospect of this happening can be very intimidating for property owners. This is why it is crucial to hire a professional that you can count on. Ensure the company is composed of engineers, tax experts and maybe even former IRS agents are proficient in the IRS guidelines for a cost segregation study.
• The Cost of the Study: A cost segregation study requires a deep understanding of construction methodology, specific business industry and tax law which can make them expensive. Many cost segregation companies will provide you with a free cost/benefit analysis to determine if the benefits will outweigh the cost. A cost segregation study that is well-executed can unlock substantial tax savings.
• The Complexity of the Study: Cost segregation studies are very complex by nature and can be overwhelming to property owners and CPAs that are unfamiliar with them. However, hiring a professional with expertise in tax law, the specific industry and construction methodology can help overcome this.
• Agreement Among Partners/Investors: If a property is owned by multiple investors, there can be differing opinions about whether to obtain a cost segregation study which can complicate and delay the decision making process. However, effectively communicating amongst the investors is paramount. All investors should be made aware of the risk, cost, and benefits associated with a cost segregation study.
• Depreciation Impact Under the Alternative Minimum Tax (AMT) System: The Alternative Minimum Tax system was created to ensure that corporations and individuals pay a minimum amount of tax regardless of credits, deductions or exemptions. Thus, property owners may be concerned that the accelerated depreciation achieved through a cost segregation study may be added back to their income, potentially increasing the tax liability. However, a well-executed tax plan can be crucial in navigating the impacts on the AMT system. Working with tax professionals on an in depth analysis of your portfolio and taxes will help them offer guidance on how the depreciation may impact your AMT system.

The complexities and challenges of a cost segregation study may discourage some property owners from leveraging this financial strategy. However, these challenges can be overcome as described above and can result in significant tax savings.

Do you have any other concerns regarding cost segregation studies?