By now, you probably heard or read about cost segregation from our previous article. It is the strategy that is used by real estate investors which provides them tremendous tax benefits from accelerated depreciation deductions and easier write-offs when an asset becomes obsolete, broken, or destroyed.
The advantages of cost segregation far exceed the disadvantages. When it comes to real estate purchases, cost segregation is the crown jewel since it allows for increased depreciation deductions.
As the preceding article demonstrates, there can be significant changes in outcomes when using it versus not using it.
- Spread Over Deductions thru slower depreciation methods
The main benefit of cost segregation is that it does not always result in larger depreciation deductions (except, of course, to the extent depreciable basis has been allocated away from the land element of the purchase). Instead, the advantage of these front-loaded deductions will be quantifiably greater than if the deductions were spread over longer periods of time using slower depreciation methods.
- Leftover tax basis can be written off.
Another benefit of cost segregation is that if a construction component needs to be replaced later, the leftover tax basis can be written off. As an example, imagine a cost segregation analysis revealed a roof’s initial worth to be $500,000. The roof will need to be replaced two years later when it has an adjusted tax basis of $480,000. A $480,000 loss could be deducted by the taxpayer. The outcome would have been radically different if the taxpayer had not conducted the cost segregation analysis; no loss could be made because the roof’s tax basis and the building’s tax basis would remain connected.
- Local realty-transfer tax reduction
Local realty-transfer taxes may be reduced as a result of cost segregation. Local governments frequently levy these fees based on the fair market value of a structure. When a cost segregation analysis lowers the value of a building, it lowers the amount of transfer tax that must be paid (and a potential reduction of annual real estate taxes as well).
There are some shortcomings in the cost segregation method. The first, and most simply quantified, is the:
- Engineering study’s actual cost
While costs vary, a well-done study does not come cheap: The price of a typical cost segregation study and written report ranges from $10,000 to $25,000. The location of the property, whether the building is new or old, the nature of the property (residential vs. nonresidential), and the time requirements for construction completion are all cost concerns. The taxpayer, like any other investor, must undertake a cost-benefit analysis. A cost segregation study should take four to six weeks to complete from the time it is first commissioned. Under IRC section 162, a business entity can deduct the cost of the study as a business expense.
- Recapture provisions of the tax code will almost certainly be triggered by the eventual disposal of the real estate acquisition
IRC section 1245 applies to tangible personal property, thus the taxpayer must recognize ordinary income, which could be subject to the highest marginal tax rate (in 2004, 35 percent ). In addition, the recapture will not be eligible for installment sale treatment. Because IRC section 1250 applies to real estate, the taxpayer must recognize unrecaptured section 1250 gain, which is taxed at a rate of 25%. (In practice, the contract for sale may normally be changed to designate a smaller percentage of the purchase price to recapture goods.)
- Penalties for those who overuse cost segregation or who obtain inaccurate information in their engineering report
IRC section 6662(a) imposes a 20% penalty on any tax underpayment resulting from a “substantial valuation overstatement.” A value overstatement occurs when the valuation exceeds the amount judged to be the accurate amount by 200 percent or more (IRC section 6662(e)(1)). However, if the overvaluation does not result in a large misstatement of taxes—that is, a misstatement of more than $5,000 (IRC section 6662(e)(1))—or if the taxpayer can prove reasonable cause and that it acted in good faith (IRC section 6664(c)(1)), this penalty will not apply.
Some taxpayers are wary of using cost segregation because they see it as a high-risk tax shelter. In reality, this fear is unjustified. The cost segregation strategy is no more aggressive than utilizing an authorized depreciation method under the Internal Revenue Code if the cost of the components in the engineering report is well-documented.
You do not have to feel the anxiety of using cost segregation if you have the right professionals by your side. All you need is a skilled tax professional to guide you through the procedure and help you decide if it’s the appropriate fit for your property.
We are here to help if you have questions on Cost Segregation feel free to contact IDM Professional Corporation CPA.