Cost segregation: Don’t overlook this valuable real estate strategy

Whether acquiring, constructing, or remodeling a real estate property, cost segregation remains one of the most powerful strategies to simultaneously optimize cash flow and taxes. Real estate developers, buyers, and investors, especially those new to the real estate investment game who are now attracted by short-term rental properties, often miss the significant tax planning opportunity presented by cost segregation studies.

These studies, typically performed by multidisciplinary teams of engineers and tax specialists, can result in substantial tax deferrals, increased cash flows, and immediate capital boosts for investment in new projects.

What is cost segregation?

A cost segregation analysis is an engineering-based study of all the costs associated with the construction or acquisition of a commercial real estate property or a residential rental property. The analysis aims to allocate the costs of constructing or acquiring a real estate property to different asset classes in order to identify the costs eligible for accelerated depreciation.

Cost segregation is applicable to almost all types of commercial properties, such as retail plazas, shopping malls, hotels, motels, restaurants, banks, warehouses, professional offices, medical offices, convenience stores, car dealerships, manufacturing plants and more. Long-term and short-term residential rental properties of all types also can qualify, whether they are single-family homes, garden- style communities, high-rise towers or affordable housing.

In the United States, for tax purposes, commercial buildings are generally depreciated using a straight- line method over a period of 39 years whereas residential rental properties used in long-term rental activities are depreciated over 27.5 years. As such, every year, over the course of a long 39-, or 27.5-year period, real estate owners receive a small portion of their construction or purchase price as a deduction for the use and obsolescence of their real property. This amount of deduction can be used to reduce their annual taxable income.

Cost segregation can improve cash flow

While this approach is relatively straightforward, it misses tax planning and cash flow optimization opportunities related to the fact that many components and items acquired or constructed with a building do not belong to the long-life real property asset class and should actually be depreciated much more rapidly. This is where a cost segregation study comes into play.

A study prepared by a cost segregation professional can identify and allocate the proper value to all those components and items that could be depreciated, with an accelerated method, over a cost- recovery period of five or seven years for items deemed “personal property” and over a period of 15 years for items pertaining to land improvements.

The cost or value of items identified as personal property and land improvements are also eligible for bonus depreciation, which can translate into their full depreciation in the first year. The result is a significant increase in the amount of depreciation deduction available to real estate investors in the critical first year of ownership. This increased amount of depreciation deduction in turn can be used to push taxes to later years and to use the cash flow for reinvestment in another project.

Several components of a real estate property may be eligible for accelerated depreciation

It’s important to understand the various components that typically fit under each asset class (i.e., real property, personal property, and land improvements) through cost segregation.

Personal property

Items within a new or acquired building that are often assigned as personal property through a cost segregation study vary depending on the type of property and the business activity taking place in the building. Items usually identified as personal property in commercial and residential rental properties include:

• components of the electrical system used to power up equipment and machinery
• decorative, display or task lighting
• carpeting or resilient flooring
• protective specialties
• appliances
• cabinets and countertops
• signs, decorative mirrors and fixtures
• window treatments
• A/V systems
• communication systems

These items will generally be eligible for classification as personal property and be depreciated over a period of five or seven years. They also qualify for bonus depreciation.

Land improvements

Items eligible for classification as 15-year land improvements, which are also eligible for bonus depreciation, include:

• parking and roadway paving
• sidewalks and curbs
• circulation signs
• stormwater management systems
• irrigation systems’
• fences and retaining walls
• decks
• certain recreational amenities
• certain landscaping components

Cost segregation studies can also be valuable with renovation, remodeling or tenant improvement projects

Cost segregation studies can provide significant tax benefits for projects that involve renovations, remodeling or tenant improvements.

For commercial properties, most of the costs associated with interior renovations that do not affect the structural framework of the existing building or do not consist in an expansion or addition to the square footage of the building, can be classified as 15-year Qualified Improvement Property (QIP). QIP is also eligible for bonus depreciation. The QIP classification is available for properties used for short-term rentals, but not for traditional residential rental properties used for long-term rentals. However, cost segregation studies on the interior renovations of these properties often identify newly installed personal property that can be depreciated over five years and is eligible for bonus depreciation. This is especially likely when a kitchen remodeling is involved.

A cost segregation study is also a valuable tool that can be used to write-off the residual value of components or systems that are disposed of upon renovation and improvements to the property. A classic example is the replacement of a roof covering. The cost segregation report can be used to determine the residual value of the old roof that was disposed of. Instead of continuing to depreciate the roof covering removed from the property, the taxpayer could write-off its residual value for additional depreciation deduction in the year of the disposal.

A cost segregation study can be a key part of tax planning and strategy

Ideally, a cost segregation study should be conducted as close as possible to the date the property was acquired or construction was completed. The study should value components at their cost as of acquisition or construction. In the case of a property acquired with the intent to renovate or remodel, it is preferable to conduct the cost segregation analysis before any demolition or replacement of existing components.

Cost segregation studies can also be performed on properties acquired or built in prior years. There is no need to amend tax returns as the accelerated depreciation can be taken on a subsequent tax return through the filing of Form 3115, Application for Change in Accounting Method.

As with most tax strategies, the use of cost segregation requires appropriate consideration and documentation. Cost segregation reports should be prepared in accordance with the IRS guidelines and a study should include references and documentation to substantiate the positions the taxpayer takes. Such guidelines include the detailed information expected to be found in a cost segregation report, the appropriate methodologies to allocate costs, as well as the sources of construction data and costs accepted by the IRS.

Some types of transactions or investment vehicles may limit the benefits that investors will receive. In addition, accelerated depreciation often interacts with other tax strategies and concepts, so your tax advisors and the cost segregation professionals should have open channels of communication.

As cost segregation involves principles of both taxation and engineering, it is recommended to work with a professional firm who has expertise in both fields. That combined expertise will help a real estate investor maximize the benefits of this valuable tax strategy.

Louis Guay is a principal of R&D tax and cost segregation services at Kaufman Rossin, the largest independent CPA and advisory firm in Florida and one of the top 100 firms in the United States. You can reach him at lguay@kaufmanrossin.com.