Welcome back to another installment of Real Estate Jargon, aka, simple explanations of sometimes confusing real estate terms. Investors in most types of income property can benefit from an accounting strategy called cost segregation. If the property was purchased, built or underwent a major remodel after 1987, cost segregation could help to improve the owner’s bottom line. Let’s look at how cost segregation works.
The objective of segregating costs is to identify improvements to a property that can be classified as “personal property,” which the IRS allows to be depreciated over fewer years than “real property” improvements such as an entire house or building.
Let’s say we’re buying or constructing a property that has a final sales price or cost of $2M. Half the value of this property is in the land and the other half is in the building. Normally, our CPA might set up a depreciation schedule that bundles the total cost of the building into one large number to be depreciated over the appropriate number of years. However, if cost segregation is implemented, we might see items broken out (segregated) for faster depreciation such as in the simple example below.
In this simple, flat line example, segregating eligible components of the building for accelerated depreciation increases our annual depreciation expense by almost $6k per year – thereby potentially lowering our tax bill. So, what building components are eligible for cost segregation and how are they identified?
A cost segregation study conducted by a qualified specialist is considered an engineering study. The specialist inspects the property and studies construction plans to identify items that have a shorter functional life than the general framework of the building. Carpets, lighting systems and some plumbing fixtures could be candidates for reclassification as personal property. Many qualified specialists are engineers and the study is often includes engineering analysis to support reclassification of eligible building components.
Cost segregation studies can cost up to $30,000 (or more) and there is no guarantee that the items qualified for segregation will produce a tax benefit sufficient to warrant the cost of the study. There are also risks that the IRS will not allow accelerated depreciation on the selected items and that depreciation recapture could cost the investor later.
If an investment property you are buying or improving could benefit from cost segregation, consult with your real estate broker (if you’re buying), your tax specialist and a cost segregation specialist for an expert opinion. The American Society of Cost Segregation Professionals (ASCSP) provides a directory of qualified specialists across the US.
I hope you found this information interesting and helpful.
NOTE: This article is an introduction to the concept of cost segregation and is not intended as tax advice. Always consult with a qualified tax specialist whenever considering any tax strategy.