Cost Segregation Residential Rental Property

Save tens of thousands on by significantly reducing your taxable income.

Group 5483

What is a cost segregation study?

Cost Segregation is the reallocation of construction-related costs from a structure’s long-term tangible property capital account balance into intangible personal property accounts for a shorter tax life. This results in accelerated depreciation deductions and may pay large tax refunds under current IRS rules for cost segregation studies.

What are the benefits of Cost segregation? 

The benefits include:

  • Identify and reallocate personal property assets to shorten the depreciation period. Personal property includes:
    • Personal computers & peripherals (9 years vs. 7 years)
    • Office furniture (7 years vs. 5 or 15 years)
    • Fixtures/equipment for manufacturing plants, laboratories, etc. (5 years vs. 3, 5, 10, or 15 years)
    • Restaurant equipment and kitchen cabinets (7 years vs. 15 years)
  • Identify personal property assets eligible for accelerated MACRS depreciation under IRS rules. Personal property includes:
    • Carpeting & other floor coverings – 3-year life – accelerated section 168(e)(3) first-year bonus depreciation deduction
    • Office partitions – 7-year life – accelerated section 168(e)(3) first-year bonus depreciation deduction
    • Appliances, HVAC units, fire sprinkler systems – 5-year life – accelerated section 168(e)(4) ADS 50% bonus depreciation deduction
  • Enhance loss on sale deductions by reallocating assets between related parties and third-party lease transactions.
  • Reduce real estate taxes by reallocating assets to shorter depreciation periods (generally, the land is not depreciable).
  • Lower self-employment taxes by shifting income from the more expensive long-term tangible property to more deductible short-term intangibles (professional offices, medical offices, retail stores).
  • Increase cash flow through tax savings.
  • Wealth creation opportunity for real estate investors and business owners.

How long does it take to complete a cost segregation study? The average cost segregation study typically takes between 7 to 10 days from start to finish, depending upon the size of the project. The larger the project, the more time required.

Does any major professional organization recognize cost segregation as an accepted accounting procedure? 

Cost segregation is an accepted accounting procedure, though the American Institute of Certified Public Accountants (AICPA) does not represent itself as a proponent of cost segregation.

How did cost segregation get its name? Cost Segregation was named by the IRS when they first wrote about it in The Chief Counsel Advice (CCA) in 1984. They used the phrase “Cost Segregation” as a “label” for this type of service, and it is now referred to as such throughout our industry.

Why would a taxpayer want to perform cost segregation on an existing building? 

Cost segregation provides accelerated depreciation deductions by reallocating costs between land improvements and personal property. As a result, the tax reduction is always a benefit for income tax purposes and sometimes results in a tax refund.

How does a typical cost segregation study work? 

Cost segregation typically starts with analyzing all contract documents to identify personal vs. structural components that have been correctly or incorrectly placed on the land improvement side of things. Provided that this is a complete and correct list, we then identify the related party transactions (i.e., leases) which are likely to reclassify costs out of capital accounts for accelerated depreciation deductions. As part of our study, we also review all prior tax returns and cost allocations by the taxpayer’s accountants—if they were prepared correctly—and also review all local taxing jurisdiction’s cost allocation manuals to ensure proper reallocation has occurred.

How do I know if my property has qualified assets for cost segregation study (CSS)? 

The general rule is that if the asset’s useful life is less than 27.5 years, it can be reclassified as personal property and must be depreciated over 5, 7, and 15 years (for residential rental) or 39 years (for commercial). Personal assets are not depreciable for income tax purposes.

What types of costs are typically identified? 

All costs necessary to place the asset in service can be reclassified. Costs that are not “necessary” are not reclassified. The most common examples of depreciable cost include, but are not limited to:

  • Site preparation/improvements
  • Structural components (columns, beams, etc.)
  • HVAC & plumbing (non-structural components) 
  • Plumbing fixtures
  • Heating, ventilating, and air conditioning equipment (HVAC)
  • Kitchen appliances/bathroom fixtures
  • Fire protection systems 
  • Security systems 

Can all costs associated with construction be included in cost segregation, even if they are not direct? 

This is a gray area in cost segregation, but the answer is yes. The key to determining whether indirect costs can be included in your project’s cost-reallocation study hinges on two important questions. First, what exactly are the “costs associated with construction?” Second, was this work done under an “accountable cost” agreement? If the answers to those two questions are yes and no, respectively, “costs associated with the construction” can be included.

Does cost segregation work on all types of properties? 

Cost segregation works on many types of buildings in almost any industry but is especially effective for hotels, multi-family properties (5+ units), retail facilities, and warehouses. It has even been used to reclassify costs on railroads, data centers, churches, and schools.

Why does an owner choose cost segregation?

 Cost segregation delivers accelerated depreciation deductions (local property tax benefits may vary) by reallocating costs between land improvements and personal property. As a result, the owner’s net cash flow increases via the reduced federal income tax obligation generated by these depreciation savings.

What is an example of how cost segregation can benefit owners? 

An example of cost segregation at work occurs when a retail building owner converts a portion of the roof into a covered and improved patio. The covered and improved patio is structurally supported by structural components such as columns, beams, or footings. Suppose the cost segregation study identifies all costs associated with this conversion, including tax payments paid upfront to reduce federal taxes in future years. In that case, the owner has the potential to exclude 100% of these costs from their basis, retire them immediately, and further reduce future federal income tax liabilities.

How effective is cost segregation at accelerating depreciation deductions for buildings? 

Cost segregation delivers accelerated depreciation deductions by reallocating costs between land improvements and personal property. The Internal Revenue Service (IRS) permits owners to annually depreciate the personal property over its shorter MACRS recovery period, whereas land improvements are depreciated over their longer 39-year useful life. The owner’s net cash flow increases via the reduced federal income tax obligation generated by these depreciation savings.

How can cost segregation benefit owners when properties are sold? 

If you sell the real property in one piece, the IRS requires that you depreciate all land improvements at their total cost. If you sell an asset with depreciable components, the buyer must include the unadjusted or “full” basis of both land and building in their purchase price. This means that if you sell a retail facility that has a higher than usual basis, you will have a higher capital gain than it should be. In this case, the buyer’s basis in the personal property is considered to be “boot” for purposes of calculating their resulting tax liability. By applying cost segregation to the building under consideration, you create additional net operating income for the retail tenant and lower your basis in the building. Now you can sell the facility as a whole, land, and improved real property for its fair market value with little or no capital gain implications.

How does cost segregation apply to new construction? 

Performing a cost segregation study on any building or renovation project is beneficial for all types of projects, whether a new construction project or a renovation. In general, the cost segregation process creates more value from new construction for both taxpayers and their customers by accelerating depreciation deductions and creating more significant intended tax savings from the start.

Does performing a cost segregation study void my building’s warranty? No, you are simply accelerating the depreciation deductions, and this puts more money in your pocket upfront without voiding any warranties.

Can cost segregation be used on raw land? Yes, cost segregation can be applied to raw land and property under development or redevelopment projects. The valuation of raw land is generally considered a “best efforts” valuation considering this area’s high degree of subjectivity.

How long does a cost segregation study take? In general, the time involved in performing a cost segregation study depends on the size and scope of your project and the level of experience you desire from your engineering firm. Generally speaking, a cost segregation study can be performed in 3-4 weeks; however, time frames may vary depending on the complexity of your project and whether or not engineering is part of the services you desire from a cost segregation engineering firm.

Is it better to do a cost segregation study before or after filing for bankruptcy? While there are no specific guidelines for performing a cost segregation study in the context of bankruptcy. Remember that tax law allows taxpayers to use either way; however, performing your cost segregation study before filing can provide more benefits than costs as you will likely be permitted to amortize the assets over the previous fifteen years.

First-Class Finance Authority

The Bottom Line Group brings 20+ Years of Cost Reduction and Tax Analysis Experience to help your business. We've saved clients more than 100k.