Whether you’re a CPA, financial advisor, or real estate investor, cost segregation can be tricky if you don’t have the correct resources or help. Hint, hint, that’s what we’re here for! We’re sure you have at least the slightest idea of what cost segregation is, but do you know how cost segregation works? We simplified the basics – keep reading to find out! Keep in mind, the IRS Cost Segregation Audit Technique Guide (ATG), which is basically a guidance document for IRS auditors, states that in order to properly calculate cost segregation depreciation, taxpayers need to follow the correct protocol in order to be IRS-compliant. This includes the ability to produce an engineering-based study. Without this component, your study can be easily scrutinized during an IRS audit. It’s that simple.
In order to properly calculate cost segregation depreciation, taxpayers need to follow the correct protocol in order to be IRS-compliant.
If you need a refresher on the basics of cost segregation, check out our blog post what is cost segregation, for a deeper dive. Cost segregation works by segregating assets into four categories:
- Land: when a property is originally purchased, the value of the land itself has to be determined. Land is never depreciated, so it must be “carved out” of the purchase price to determine the depreciable basis of the property’s improvements.
- Land Improvements: Auxiliary improvements such as landscaping, roads, and fences are examples in this category. These components must be extracted from the total property improvements to determine the building’s basis.
- Personal Property: assets that are not structural components of the building may be considered tangible personal property, and may potentially be depreciated sooner than the building itself. These include items like office furniture, floor coverings (vinyl/carpet), and some electrical components and fixtures.
- Structure: this covers the basic shell of the building – the so-called “structural components.” These components typically remain as 39-year property, but the Cost Segregation process should quantify individual parts such as roofing, elevators, and boilers that may be replaced individually in the future. By quantifying their values up front, their remaining basis can be fully written off in the years they are replaced.
The below chart gives a good example of how cost segregation works from a benefit perspective. Although the actual benefit amount varies for everyone, the trend outlined is comparable across the board.
The blue represents how much of your deduction you can hold onto interest-free. Remember that with cost segregation, your current tax liability is reduced upfront, thus allowing you to hold onto more of your cash (instead of handing it over to the Feds). It is important to note that, at the end of the lifespan of the building, your depreciation will always end up totaling the basis of land improvements, personal property and structure. The green, in the chart above, represents the return you can potentially make with your cost segregation deduction, over the life of the building. Of course, this assuming an average rate of return. Worth it? I think so.
With cost segregation, your current tax liability is reduced upfront, thus allowing you to hold onto more of your cash.
Depreciating Assets
When it comes to the nitty gritty of depreciating assets, it is important to keep in mind that there’s a blurred line with differentiating between “assets.” Assets are segregated under properties known as Section 1245 (tangible or personal property) and Section 1250 (real property). Section 1245 assets can be removed and not part of the building’s structure. Examples include:
Carpet
Furniture
Certain Lighting fixtures
Section 1250 assets are considered to be a part of the building. Examples include:
Most Doors
Windows
Stairs
Plumbing
Although that was quite a bit of information to soak in, rest assured, cost segregation doesn’t have to be difficult. Here at Titan, our goal is to simplify and maximize the benefit of cost segregation for you. We offer the Echo Learning Academy, a knowledge base that provides detailed guidance for learning how to run your own cost segregation study.
Assets are segregated under properties known as Section 1245 (tangible or personal property) and Section 1250 (real property).
Ready to find out how cost segregation can help you? Get access to Titan Echo and start running cost seg benefit estimates.
