For those who have recently purchased or built a new building, or even substantially remodeled an existing building that they own, faster write-offs are only a cost segregation study away. A cost segregation study identifies property components and their cost, allowing owners to maximize their current depreciation deductions by using the shorter lives and faster depreciation rates available for the qualifying parts of the property. But the overall benefit may be limited in certain circumstances. This article explores some of the details, while addressing the concern some have as to whether a cost segregation study might trigger an audit.
Use a cost segregation study to accelerate tax deductions
As a real estate investor, you’ve undoubtedly looked for ways to get faster write-offs from your properties in order to minimize income taxes in this sluggish economy. Well, there’s good news: If you’ve recently purchased or built a new building, or even substantially remodeled an existing building that you own, faster write-offs are only a cost segregation study away.
Why a cost segregation study?
Real estate can be segregated into four basic categories of property: buildings, land, land improvements and personal property. Buildings are generally depreciated over 27.5 (residential rental) or 39 (commercial) years using the straight-line method. Land isn’t depreciable at all.
But you can typically depreciate land improvements over 15 years using 150% of the straight-line rate on the declining balance, and most personal property over five or seven years using 200% of the straight-line rate. Often, however, these property components are misclassified.
A cost segregation study identifies property components and their cost, allowing you to maximize your current depreciation deductions by using the shorter lives and faster depreciation rates available for the qualifying parts of the property.
For example, if $400,000 of assets were reclassified as seven-year vs. 39-year property, your depreciation deduction in the first year, assuming the building was placed in service around midyear, would increase from around $5,000 to over $57,000.
There are no hard-and-fast rules for distinguishing personal property eligible for accelerated depreciation from structural components that must be depreciated as part of the building. The answer depends on a number of factors, including how the property is affixed to the building, whether it’s designed to remain in place permanently, and how difficult it would be to move or remove.
Examples of personal property that can qualify for a faster depreciation deduction include decorative fixtures, cabinets and shelves, movable wall partitions, carpeting, security equipment and so forth.
Even certain plumbing, wiring, and heating and air conditioning vents and lines — which you’d normally think of as part of the building — may be eligible for shorter lives if they’re specifically required for equipment that has a shorter life (such as wiring for the security system). You can also depreciate the allocated portion of certain capitalized indirect or overhead costs — such as architectural and engineering fees.
Examples of land improvements you can isolate with a cost segregation study include parking lots, sidewalks, fences and landscaping.
Be mindful of limitations
Consider a cost segregation study when you buy, build or remodel — or when you have done so within the last few years. But be mindful that the overall benefit of a cost segregation study may be limited in certain circumstances, such as when the business is subject to the alternative minimum tax (AMT) or is located in a state that doesn’t follow federal depreciation rules. Passive activity loss rules can also defer the benefits (see Don’t lose out on rental real estate losses).
The cost of the study generally pays for itself if the building or remodeling expenditures are fairly substantial and were completed or purchased fairly recently.
Bring in the experts
Because cost segregation studies have so many variables, it’s critical that you retain the services of a cost segregation expert. He or she will work with a valuation professional to create a report of the assets, prepare the forms and crunch the numbers. If you’ve bought, built or remodeled property fairly recently or are in the midst of doing so today, you owe it to yourself to explore how a cost segregation study can help you reap faster tax write-offs.
Could a cost segregation study trigger an audit?
Some business owners forgo cost segregation studies for fear of getting audited. But you’ll be well prepared for an audit if the cost segregation study is performed by an experienced and competent tax or financial advisor. Taxpayers who perform a cost segregation study can qualify for an automatic accounting method change — a pretty simple procedure.
The bottom line is that taking advantage of a cost segregation study performed by a professional generally won’t increase the likelihood of an audit, and you’ll have the support to survive an audit if one occurs.
Cost Segregation and the Cash Flow Analyzer® software
As you already may know, our Cash Flow Analyzer® software has the most comprehensive tax analysis built-in and at your figure tips. One of the powerful features is the ability to break out a property’s purchase price into the various property classes for tax purposes. You can quickly and easily see the impact of the accelerated depreciation in the income tax analysis and its effect on your return on investment.
Douglas Rutherford, CPA
© 2011 Douglas Rutherford, CPA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA. Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing.