One of the most powerful tools in the tax toolbelt for real estate developers and investors is cost segregation. Veterans of the real estate industry are well aware of the tax benefits of cost segregation, yet many taxpayers may not really know what it is. This article will attempt to demystify the concept with the most common questions we encounter.
What is cost segregation?
Cost segregation is an engineering-based approach to classify various components of buildings into their appropriate depreciable classes. By breaking down a building’s costs into shorter-lived assets, real estate investors can accelerate depreciation deductions, resulting in reduced taxable income during the initial years of the investment.
What are depreciable classes, and how is it determined if they are appropriate?
Depreciable classes are provided by the IRS to establish the time period and convention for taking depreciation on fixed assets. Depreciation is taken over 39 years for nonresidential real property and 27.5 years for residential real property. In the cost segregation process, a portion of the depreciable basis of a building is most commonly allocated to land improvements (depreciated over 15 years) and distributive trade assets (depreciated over five years). As a result of shorter depreciable lives for a portion of the building basis, taxable income is reduced in the initial years of the investment through accelerated depreciation deductions.
A second benefit to the shorter depreciable lives of land improvements and distributive trade assets for buildings is this amount will generally become eligible for additional first-year (or bonus) depreciation. Prior to the Tax Cuts and Jobs Act of 2017, only brand new constructed real property was eligible for bonus depreciation with a cost segregation study. The tax reform bill expanded the benefit to purchases of existing real property in addition to new construction. This expansion, in conjunction with 100% bonus depreciation on qualifying assets placed in service between September 27, 2017, and December 31, 2022, resulted in a significant tool for real estate investors to accelerate deductions and reduce taxable income.
And the IRS is okay with this?!?
Yes! As long as you have a qualified professional providing the analysis, the IRS will allow these accelerated tax deductions. In several court cases and rulings, it has been established that various components of a building serve a purpose outside of being purely structural components of the building. This is where the engineers come in. As of June 2022, the IRS’ audit guide is 268 pages and underlines that the IRS is well aware of this strategy for accelerating depreciation.
One of the key elements that the IRS will look at when auditing a cost segregation allocation is the expertise and experience of the individual preparing the analysis. Most CPAs do not have the proper engineering and construction background to properly do this analysis and generally rely on specialty firms to produce the study that will be used on the tax return. (If you’re in the market for a cost segregation study, check out our talented team of real estate professionals specializing in cost seg studies.)
What kind of properties can cost segregation be used on?
Cost segregation can be utilized for both residential and nonresidential real estate. The benefits can vary widely, though, since it’s dependent on identifying components of the real property that are nonstructural and will be eligible for shorter class lives. For example, a manufacturing facility will typically yield more accelerated deductions than a warehouse will since more specialty work will be needed for the manufacturing process than would otherwise be required for the building.
When can cost segregation be used?
Taxpayers can utilize cost segregation in any tax year they own the real property. If used in a year after the property was placed in service for depreciation, the taxpayer can catch up on depreciation deductions they were entitled to under cost segregation by filing a change of accounting method.
Who is cost segregation ideal for?
Cost segregation provides the most benefit for materially participating real estate professionals. For taxpayers that meet the qualifications for this designation, if the depreciation from a cost segregation study creates a taxable loss, they can use the losses against any other business income and up to $500,000 of income from nonbusiness sources during the tax year. Cost segregation can also provide a benefit for investors who have multiple passive investments. Although passive investors cannot use losses to offset nonbusiness income, they can use them to offset business income they do not materially participate in.
What risks are associated with cost segregation?
The main risk of cost segregation is taking accelerated depreciation on a tax return without a qualified individual providing the analysis. There is no indication that using cost segregation increases the risk of an IRS audit, even if it is taken by filing a change of accounting method. If the return is selected for audit, though, it would be highly unusual for the IRS not to look closely at the methodology used in determining the shorter class lives. It is recommended when looking at providers of cost segregation studies that inquiries are made regarding their IRS audit experience and what level of support they provide in the event of an audit.
Could 100% bonus depreciation be on its way back?
The Tax Relief for American Families and Workers Act, which passed in the House earlier this year, proposes the restoration of 100% bonus depreciation. Your Perkins team is monitoring the legislation closely to see if it will pass the Senate this year.
While we await Congressional action, learn more about how bonus depreciation could change in the years ahead and what bonus depreciation opportunities exist for real estate businesses independent of pending legislation. Don’t hesitate to reach out to any of the knowledgeable Perkins real estate professionals with questions on how these benefits may apply to your specific tax situation.
This article was originally published on July 31, 2023. It has been updated to provide readers with the information needed to thrive in today’s real estate market.