Cost Segregation – A Useful Tool for CPAs
A common depreciation scheme for a real estate purchase is to incorporate the entire cost of the building into a 39-year straight-line depreciation schedule. The cost segregation approach to depreciation provides a money-saving alternative that can lower tax bills and increase cash flow.
Under cost segregation, the costs are divided into categories that may be depreciated under different schedules. Some elements of the property can be changed from IRC section 1250 real property to IRC section 1245 tangible personal property, allowing for shorter depreciable lives and accelerated write offs of these capital costs.
CPAs may be able to save significant money for their real estate clients by recommending a cost segregation strategy – if they can confidently assess the benefit against the client’s tax position.
Cost Segregation Benefits
Cost segregation allows CPAs to depreciate certain assets for their real estate clients on a shorter life cycle and accelerated schedule, potentially saving many thousands of dollars in taxes. Clients can reinvest their tax savings to take full advantage of the time value of money.
There are delayed benefits as well as current ones. By using cost segregation, components of an asset that may need future replacement (such as the roof of a building) should be quantified as part of the remaining 1250 property. This allows the CPA to depreciate the remaining value of that component in the year of a replacement, without an additional cost to identify the component’s basis.
Since clients receive both current and future benefits, why doesn’t everyone use the cost segregation method? The primary downside is cost.
A Cost Segregation Engineering study can cost well over $10,000. However, software such as the Titan Echo platform can allow CPAs to inexpensively verify the tax benefits and quickly complete a detailed study, if warranted.
As a rule of thumb, with the use of Titan Echo, cost segregation is a viable strategy for $500,00 buildings, and possibly buildings even smaller.
What is Involved in a Cost Segregation?
The initial real estate purchase is subdivided into the land value, land improvements, and the building itself. Individual components of the land improvements and building are then further segregated and classified according to the Modified Accelerated Cost Recovery System (MACRS). Some examples of segregated tangible personal property are:
- Personal property items such as fixtures, drapes, carpets, and furniture may be split out and depreciated over a 5-7 year schedule with accelerated methods.
- Landscaping, decks, sidewalks, and roads may be considered as land improvements, and depreciated separately over a 15-year life with accelerated methods.
- Components of the building (in essence, the shell) are subdivided into elements that serve as the baseline value for any future replacement costs. Because of the potential future write off in case of replacement, it makes sense to maximize them to the extent possible even though there are no immediate depreciation advantages.
It is not always obvious how finely to divide the assets to be classified, and even trickier to properly establish the cost basis them – especially between personal property and building elements. Items such as lighting and wall coverings may fall into either category depending on factors like utility and ease of removal. The evolution of court cases on this issue helps to distinguish between these categories.
The bottom line is that CPAs can leverage this tax strategy for their clients by understanding and applying the principles of cost segregation. In addition, efficiently determining the available savings early in the evaluation eliminates the risk of investing in a study that doesn’t ultimately produce the originally estimated benefit. Saving time and money in this assessment is good for both the CPA and their client. That’s a win-win situation.