Frequently Asked Questions
Cost Segregation
What is cost segregation?
At its core, cost segregation involves reclassifying assets within a building to accelerate depreciation. Instead of treating the entire property as a single asset with a 27.5-year or 39-year depreciation period (as per standard IRS guidelines), cost segregation allows you to break down the components into shorter-lived categories. These categories include:
- Personal Property: Items like carpeting, lighting fixtures, appliances, and furniture.
- Land Improvements: Sidewalks, landscaping, and parking lots.
- Building Components: Structural elements like roofing, HVAC systems, and electrical wiring.
By identifying and segregating these components, you can depreciate them over shorter periods (typically 5, 7, or 15 years), resulting in significant tax savings.
How Does It Work?
- Cost Segregation Study:
- To implement cost segregation, start by hiring a qualified professional to conduct a cost segregation study.
- During this study, they analyze your property’s construction costs, blueprints, and other relevant documents.
- Component Identification:
- The study identifies which components qualify for accelerated depreciation.
- For example, while the building structure itself has a long lifespan, the carpeting or lighting fixtures may have a much shorter useful life.
- Reclassification:
- Once the components are identified, they are reclassified into the appropriate depreciation categories.
- This allows you to claim higher depreciation deductions in the early years of ownership.
- Tax Benefits:
- By accelerating depreciation, you reduce your taxable income, which in turn lowers your tax liability.
- The freed-up capital can be reinvested or used for other purposes.
Eligibility and Considerations
- Property Types:
- Cost segregation applies to various types of investment properties, including residential, commercial, and industrial real estate.
- However, it does not apply to primary residences.
- Feasibility Analysis:
- Before proceeding, assess whether cost segregation makes sense for your property.
- Factors include property size, construction costs, and your long-term investment goals.
- IRS Compliance:
- Ensure that your cost segregation study adheres to IRS guidelines.
- The study report should be well-documented and supported by construction cost data.
Cost segregation is a powerful tool for real estate investors seeking to maximize their tax benefits. By accelerating depreciation, you can improve cash flow, and enhance returns.
What are the benefits of cost segregation?
Cost segregation is a tax strategy that can significantly impact your bottom line. Whether you own residential or commercial investment properties, understanding the pros and cons of cost segregation is essential. Let’s dive into the benefits:
Reduce Your Tax Liability
Without cost segregation, your property is depreciated over long periods (27.5 years for residential and 39 years for commercial). However, cost segregation breaks down various building components (from appliances to landscaping) and categorizes them. These components can be depreciated on an accelerated schedule of five to 15 years. Accelerated depreciation increases your deductions, leading to a lower tax bill and, in some cases, even a tax refund.
Retroactively Claim Depreciation
Missed the initial cost segregation study? With a look-back study, you can retroactively accelerate depreciation on qualified components. This can lower your tax liability and, for some business owners, result in an IRS tax refund. You don’t need to file an amended return; just submit IRS Form 3115 to change your accounting method.
Cash In On Bonus Depreciation
In addition to accelerated depreciation on building components, you can claim bonus depreciation. The Tax Cuts and Jobs Act allows property owners to write off 100% of eligible property costs in the first year. Although bonus depreciation will phase out starting in 2027, it’s still available at varying rates until then:
- 2018: 100%
- 2019: 100%
- 2020: 100%
- 2021: 100%
- 2022: 100%
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
Taking advantage of this immediate deduction can result in significant tax savings for property owners.
Increase Cash Flow
Cost segregation frees up cash flow by reducing your tax burden. These additional funds can be reinvested in your business or other properties, allowing for further growth and expansion.
Optimize Purchase Price Allocations
When acquiring properties, cost segregation helps you allocate the purchase price more effectively. By identifying short-lived assets separately, you can maximize depreciation deductions and improve your overall financial position.
Determine True Insurable Replacement Cost
After exclusions, cost segregation provides a clearer picture of your property’s true insurable replacement cost. This knowledge is crucial for insurance coverage and risk management.
Establish Real Market Value
By factoring in exemptions, cost segregation helps establish the real market value of your property. This information is valuable for financial planning, refinancing, and property transactions.
In summary, cost segregation isn’t just about tax savings—it’s about unleashing hidden value within your property. Consult with a tax professional to determine if cost segregation is right for your situation. Remember, every property is unique, and the benefits may vary.
What documents do I need for a cost segregation study?
- Purchase Contract
- Closing Statement
- Appraisal
- Property Inspection Reports
- Property Detail Report
- Shop Drawings
- Cost Details
- Fixed Asset Schedule
What are the bonus depreciation rates?
Additional First Year Depreciation Deduction (Bonus)
|
Date Range |
Bonus Rate |
|
9/11/2001 - 5/5/2003 |
30% |
|
5/6/2003 - 12/31/2004 |
50% |
|
1/1/2005 - 12/31/2007 |
0% |
|
1/1/2008 - 9/8/2021 |
50% |
|
9/9/2010 - 12/31/2011 |
100% |
|
1/1/2012 - 9/27/2017 |
50% |
|
9/28/2017 - 12/31/2022 |
100% |
|
1/1/2023 - 12/31/2023 |
80% |
|
1/1/2024 - 12/31/2024 |
60% |
|
1/1/2025 - 12/31/2025 |
40% |
|
1/1/2026 - 12/31/2026 |
20% |
|
1/1/2027 - |
0% |
How do you calculate land allocations?
CostSegRx does not provide land allocations. It is up to you as the property owner to decide a reasonable land allocation for your property. We recommend that you document how you determined the land allocation and save it with your property documents.
These 6 methods can provide you with guidance:
Assessed Value: The county tax assessor often lists the land allocation as a percentage of the total property value, see The Conroe Office Building, Ltd v. Commissioner, T.C. Memo 1991-224.
Appraiser’s letter: If your appraisal properly lists a land allocation this is a valid method, see 1973 Revenue Ruling 73-410.
Average of CPA’s estimate and assessed value: This rule-of-thumb method is based on a specific geographic area, see Aarol Irish, TC Memo 1969-45
Replacement Cost New (RCN): Once the cost segregation study has been completed, we can look at this option. Example: Land Allocation = RCN - Purchase Price, see Meirer v. Commissioner T.C. Memo 1982-51
Reproduction Cost New (RCN) Less Rehab Cost: Once the cost segregation study has been completed, we can look at this option. Example: Land Allocation = RCN - Rehab Cost - Purchase Price, see Westory (6 AFTR 2d 5392)
Adjusted Reproduction Cost New (RCN): Once the cost segregation study has been completed, we can look at this option. Example: Land Allocation = RCN X Depreciation Adjustment - Purchase Price, see Weis v. Commissioner 94 TC 473
How do you calculate the cost basis of real estate?
The cost basis of real estate is the original value or purchase price of the property for tax purposes. It’s an essential factor when depreciating and determining capital gains or losses upon selling the property. Here are some key points related to cost basis according to IRS Publication 551:
Basis of Property:
- The basis of property is used to calculate depreciation, amortization, depletion, and casualty losses.
- It’s also crucial for determining gain or loss when selling or disposing of the property.
- Accurate records of all items affecting the basis must be maintained for these computations.
Cost Basis:
- The basis of property you buy is typically its cost.
- Additionally, certain other costs related to buying or producing the property may need to be capitalized (added to the basis). For example, you may add the closing costs to the basis if the closing costs are as if you paid cash for the property. Loan costs can not be added to the basis they should be amortized over the loan period.
Adjusted Basis:
- Your original basis in property can be adjusted (increased or decreased) due to specific events.
- For example, making improvements to the property increases the basis, while deductions for depreciation or casualty losses reduce it.
Exceptions:
- Some assets cannot have their basis determined solely by cost. This includes property received as a gift, inheritance, or through involuntary conversion.
- In such cases, other methods are used to establish the basis.
CostSegRx does not provide the cost basis of Real Estate. We recommend reviewing your purchase contract, closing statement, and a detailed list of improvements to determine the Cost Basis.
Can I add my personal labor in the cost basis of real estate?
No, unfortunately you cannot add your personal labor in the cost basis.
You can add the cost of labor you paid 3rd parties in the cost basis. See IRS Publication 551.
How do you qualify as a real estate professional?
Read IRS publication 925 Passive Activity and At-Risk Rules and section 469(c)(7) of the Internal Revenue Code for detailed information on the requirements and qualifications to become a Real Estate Professional.
Here is a quick summary:
To qualify as a Real Estate Professional according to the IRS, you must meet the following requirements:
- More than half of your personal services during the tax year must be performed in real property trades or businesses in which you materially participated.
- You must spend 750 hours or more in the real property business and rentals in which you materially participate.
If you meet these criteria, you can report income or losses from rental real estate activities in which you materially participated as nonpassive income or losses on line 43 of Schedule E (Form 1040).
It's important to note that meeting the qualifications outlined by the IRS does not guarantee nonpassive income treatment for tax purposes, as other factors may also be considered.
Becoming a Real Estate Professional can have significant tax benefits, but it's crucial to understand and follow all IRS guidelines and regulations.
Always consult with a tax professional to ensure accurate compliance with IRS guidelines.
I am not a real estate professional, should I get a cost segregation study?
Coming Soon
Can I do a cost segregation study on a vacation rental?
Vacation rentals, such as Airbnbs and Vrbos, have emerged as excellent properties for cost segregation studies. These short-term rental properties offer unique opportunities for owners to utilize accelerated depreciation methods to offset their taxable income.
Owners of vacation rentals often face challenges in accurately depreciating their properties. Traditional depreciation methods, which spread the cost of the property over its useful life, may not adequately reflect the high wear and tear associated with short-term rentals. Cost segregation studies provide a solution by identifying and categorizing the different components of a property, such as furniture, appliances, and building systems, and assigning each category a specific depreciation schedule.
By conducting a cost segregation study, vacation rental owners can allocate a larger portion of their property's cost to shorter-lived assets, resulting in higher depreciation deductions in the early years of ownership. This accelerated depreciation can significantly reduce taxable income and provide substantial tax savings.
In addition, the nature of vacation rentals, with their frequent turnover of occupants, leads to higher levels of wear and tear compared to long-term rentals. The constant use and abuse of furnishings, appliances, and other personal property necessitates more frequent replacements. Cost segregation studies take this into account by considering the shorter useful lives of these assets and recommending appropriate depreciation methods.
Owners of vacation rentals should consider engaging in a cost segregation study to maximize their tax benefits and optimize their financial performance. The potential savings from accelerated depreciation can be significant and can positively impact the profitability of their investment.
If you have a vacation rental property feel free to book a call.
Should I do a cost segregation study on a property that I am planning to sell?
The answer is typically no but it will depend on your specific tax strategy.
Pros: You may be able to offset current taxable income.
Cons: You will be subject to depreciation recapture.
What is the legal justification for cost segregation?
The Tax Reform Act of 1986 (TRA 86) requires that taxpayers use the modified accelerated cost recovery system (MACRS) of depreciation for most tangible depreciable property placed in service after December 31, 1986. The deduction for depreciation of MACRS property is determined by applying the applicable property class, the applicable recovery period, and the applicable convention.
In addition to the MACRS method of depreciation, the taxpayer is required to apply the principles set forth in Rev. Proc. 87-56. The Revenue Procedure states that in order to depreciate property accurately, a taxpayer must first identify the asset depreciation range (ADR) class in order to establish an ADR midpoint life (Rev. Proc. 87-56). Then, the appropriate ADR midpoint life should be cross-referenced against eight property classes as outlined in the TRA 86 so that an accurate method of depreciation is established. See https://www.irs.gov/publications/p946
What are the elements of a quality cost segregation study?
- Detailed description of the methodology
- Use of appropriate documentation
- Interviews conducted with appropriate parties
- Use of common nomenclature
- Explanation of the legal analysis
- Determination of unit costs and engineering “take-offs”
- Organization of assets into lists or groups
- Use of standard numbering system
- Identification and listing of section 1245 property
- Reconciliation of total allocated costs to total costs
- Explanation of the treatment of indirect costs
- Consideration of related aspects
What are the asset classes used in a cost segregation study?
|
Asset Class |
Description of assets included |
Class Life |
GDS |
ADS |
|
00.11 |
Office, Furniture, Fixtures, and Equipment: Includes furniture and fixtures that are not a structural component of a building. Includes such assets as desk, files, safes, and communication equipment. Does not include communications equipment that is included in other classes. |
10 |
7 |
10 |
|
00.12 |
Information Systems: Includes computers and their peripheral equipment used in administering normal business transactions and the maintenance of business records, their retrieval and analysis. Information systems are defined as: 1) Computers: A computer is a programmable electronically activated device capable of accepting information, applying prescribed processes to the information, and supplying the results of these processes with or without human intervention. It usually consists of a central processing unit containing extensive storage, logic, arithmetic, and control capabilities. Excluded from this category are adding machines, electronic desk calculators, etc., and other equipment described in class 00.13. 2) Peripheral equipment consists of the auxiliary machines which are designed to be placed under control of the central processing unit. Non Limiting examples are: Card readers, card punches, magnetic tape feeds, high speed printers, optical character readers, tape cassettes, mass storage units, paper tape equipment, keypunches, data entry devices, teleprinters, terminals, tape drives, disc drives, disc les, disc packs, visual image projector tubes, card sorters, plotters, and collators. Peripheral equipment may be used online or offline. Does not include equipment that is an integral part of other capital equipment that is included in other classes of economic activity, that is, computers used primarily for process or production control, switching, channeling, and automating distributive trades and services such as point of sale (POS) computer systems. Also, does not include equipment of a kind used primarily for amusement or entertainment of the user. |
6 |
5 |
5 |
|
00.3 |
Land Improvements: Includes improvements directly to or added to land, whether such improvements are section 1245 property or section 1250 property, provided such improvements are depreciable. Examples of such assets might include sidewalks, roads, canals, waterways, drainage facilities, sewers (not including municipal sewers in class 51), wharves and docks, bridges, fences, landscaping shrubbery, or radio and television transmitting towers. Does not include land improvements that are explicitly included in any other class, and buildings and structural components as defined in section 1.48-1(e) of the regulations. Excludes public utility initial clearing and grading land improvements as specified in Rev. Rul. 72-403, 1972-2 C.B. 102. |
20 |
15 |
20 |
|
57.0 |
Distributive Trades and Services: Includes assets used in wholesale and retail trade, and personal and professional services. Includes section 1245 assets used in marketing petroleum and petroleum products. |
9 |
5 |
9* |
* Any high technology medical equipment as defined in section 168(i)(2)(C) which is described in asset guideline class 57.0 is assigned a 5-year recovery period for the alternate MACRS method.
What is the ASCSP?
The ASCSP is the American Society of Cost Segregation Professionals. This national society is focused on continuing education, certification, and minimum quality standards to assist taxpayers and their professional advisors, with making informed decisions on the selection of a qualified cost segregation provider.
