Accelerate It!

A cost segregation study can allow you to benefit from an accelerated depreciation timeline for some building components.

By ANYA SMELEK, The Ambrose Group

Virtually every taxpayer who owns, constructs, renovates or acquires a commercial real estate structure stands to benefit from a cost segregation study. By ignoring generous IRS guidelines when establishing depreciation schedules, over 90% of real estate investors are unintentionally overpaying federal income taxes. In addition, they are paying federal income taxes earlier than necessary.

What is a cost segregation study?

Cost segregation is an IRS-approved income tax strategy that allows commercial property owners the opportunity to accelerate the depreciation of their asset by reclassifying components of the real estate into 5-, 7- or 15-year life, as compared to 39- or 27.5-year life. Cost segregation is a tax strategy that can help real estate owners accelerate depreciation deductions for their properties, potentially reducing their tax liabilities and increasing cash flow. By separating real property assets into different asset classes, cost segregation enables property owners to improve their tax planning by taking full advantage of tax benefits available for different types of property expenses.

A cost segregation study is a process that looks at each element of a property, splits them into different categories, and allows you to benefit from an accelerated depreciation timeline for some of those building components.

Why does a cost segregation matter to multifamily property owners?

Segregating the costs of a property matters because of the financial benefits it provides. While the study has a fee, the tax savings from accelerating depreciation deductions can result in significantly increased cash flow over several years.

With a cost segregation study, you get the benefits of up-front money from the tax savings. It is important to note that if you do not plan on holding the property for more than three years, you may not get a benefit from having a cost segregation study because any up-front benefits reverse upon the sale of the property (capital gains).

The tax strategy of cost segregation provides the following benefits to multifamily property owners:

• An immediate increase in cash flow

• A reduction in current tax liability

• The deferral of taxes

• The ability to reclaim missed depreciation deductions from prior years

Who performs a cost segregation study?

Performing a study on your own is not very practical. A cost segregation study involves an engineer or other qualified professional, segregating the various components of a property into different asset classes, based on IRS rules and regulations.

When should a sost segregation study be performed?

The best time to conduct a cost segregation study is in the year the building is acquired, constructed or remodeled. However, you can have a look-back study done any time afterwards and claim the resulting write-offs without amending prior-year tax returns. In some cases, a cost segregation study can be done for significant repairs and maintenance expenses associated with the property, resulting in more and immediate depreciation deductions.

A cost segregation study example for a multifamily property

Without cost segregation, tax rules allow multifamily assets to be depreciated over 27.5 years using a straight-line methodology. This means that depreciation expense is calculated by dividing the property’s basis by 27.5.

For example, you buy a multifamily unit for $1.2 million. Land is not depreciable and must be taken out of the purchase price. The engineer or qualified professional decides that the land is worth $200,000 and now your basis is $1 million. That can be divided by 27.5 to obtain $36,363 in an allowable depreciation write-off each year.

Using the cost segregation strategy, the owner can increase their allowable depreciation from roughly $36,000 to $55,000 by reclassifying their personal property, land improvements and building into 5-, 7- or 15year life.

• $100,000 of interior fixtures and finishes that can be depreciated over five years, providing $20,000 in annual depreciation expense

• $150,000 of interior fixtures that can be depreciated over seven years, providing $21,428 in annual depreciation expense

• $200,000 of land improvements that can be depreciated over 15 years, providing $13,333 in annual depreciation expense

Below are some examples of those components:

• Personal property: This category includes items such as furniture, carpeting, lighting fixtures and window treatments.

• Land improvements: This category includes items such as sidewalks, fences and docks.

• The building: The building’s components, such as the roof and plumbing systems, can be attributed to this category.

It should be noted that the above is an example for educational purposes only. An actual cost segregation study is performed by an expert with the required qualifications and expertise in that field.

Cost segregation can be an effective strategy to reduce tax liabilities and increase cash flow for those in the real estate industry. The accelerated depreciation allowed by these shorter building lives is what makes cost segregation so attractive, especially for those who own a significant amount of real estate. By claiming more depreciation up-front, the property owner can offset their income with these deductions, reducing their tax liability and increasing their cash flow. If you own real estate, it's worth considering a cost segregation study to maximize your tax benefits and improve your overall financial position.

Anya Smelek is the Marketing & Business Development Manager at The Ambrose Group. With 30 years of experience, The Ambrose Group has become a leader in the valuation of real estate, engineered Cost Segregations and tax consulting services. For more information, visit www.theambrosegroup.com or email asmelek@theambrosegroup.com.