Cost Segregation Residential Rental Property

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

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.

Here's everything you need to know about Cost Segregation

Cost Segregation Depreciation Guide is an educational guide to help investors understand, implement and maximize the tax strategy known as cost segregation.Cost Segregation is a guide to reduce taxes and maximize cash flow while often paying for itself in a couple of years. Cost segregation benefits both real estate investors and business owners by allowing them to reallocate certain expenditures, which can help to reduce income and increase cash flow.The goal of cost segregation is to apply specific percentages (which we call Cost Segregation Studies) to particular assets to determine their tax life for depreciation purposes. The results are summarized in a report, which usually consists of several categories for depreciable assets, such as:

  • 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.

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

Each business may apply different processes for cost-analysis and cost-cutting. But in most cases, it all starts with a compilation of all business expense statements. A cost reduction consultant will gather information and identify the business operating expenses so that they can create a comprehensive cost-reduction analysis that is unique to your business.

The next process that most cost reduction consulting firms take is to analyze the operating expenses of the business. To maximize savings, consultants will take a look at all the aspects of your overhead, such as Office Machine expense, human resources administration costs, finance and accounting costs, marketing and advertising expense, telecommunication expense, insurance costs, and many others.

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 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.

Medical Insurance

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.

Start with strategy

The cost reduction analysis should start with a clear picture of the strategy to make sure that there is a consistent understanding of the organization. A cost reduction analysis cannot be carried out if the business strategy is not fully understood because it may not be clearly defined. The entire organization should be on the same page with regards to its business strategy, otherwise, any attempt by one unit to institute cost reduction will not be understood and will not gain any help and support from the other units.

Align costs to strategy

The cost reduction analysis should look across the whole organization, differentiating the critical good costs from the non-essential bad costs. If the strategically-critical good costs are necessary to maintain the high quality of the products or the services, they should not be touched. It should be the non-essential bad costs that should be reviewed for possible reduction or, when necessary, elimination.

Aim high

Aim high when working on new ways to radically optimize the cost base. The company can be bold, creative, and brave in the use of innovation and technology to help you find ways of reducing value that will make the product or service competitive while at the same time maintaining its high quality.

Set direction and show leadership

The manager who is tasked to do the cost reduction analysis must deliver cost optimization as a strategic, business transformation program. Cost reduction should not be a short-term thing that will be abandoned when working with another product. The cost reduction program should be a company-wide endeavor that is aimed to transform the way business is conducted.

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