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Using Cost Segregation in Real Estate Tax Strategy

By Gabriel Florentino, Client Development Director of Engineered Tax Services

Exploring the Layers: A Detailed Breakdown of Lighting, HVAC, and Plumbing Systems in a Multi-Level Commercial Structure for Cost Segregation Purposes

What is Cost Segregation?

A cost segregation study is a federal income tax tool that increases your near-term cash flow by deferring taxes.

With a cost segregation analysis, you could be able to write off up to 30-35% of your building’s original purchase price in the first year!

Because depreciation occurs when a purchased building ages, it loses value over time. Actually, your building is not only one piece of property, but comprised of subcomponents (such as lighting fixtures, heating and air conditioning systems, and other components that deteriorate over time).

But unlike the whole of a building, which is seen as having either 27.5- or 39-year lifespan, subcomponents are granted a five- or 15-year lifespan, making the depreciation deduction larger, especially in the first several years. Consequently, whether your property is residential or commercial, you can write off that cost either in a 27.5- or 39-year timeframe.

Learn About The History of Cost Segregation

How Much Money Could You Save?

Since many components can be written off after a cost segregation study, if your purchase price was $1 million (for instance), you can deduct $300-400,000 immediately. Consequently, if you only invested $100,000 of your own money and borrowed the other $900,000, you’ve only spent $100,000, but received a $300,000 deduction!

For example, let’s assume you’re classified as a real estate professional or you have material participation in a commercial real estate investment, with a $100,000 salary. Because you can apply your $300,000 deduction to offset taxable income, you’re only paying taxes on $700,000!

With our expertise, we can uncover potential tax savings and increase your cash flow by reclassifying and depreciating your property. As a result, you can accelerate the return on capital from your property investment.

As part of our reporting process, Engineered Tax Services provides a detailed engineering report and works seamlessly with the IRS and your CPA firm for minimal disruption to your business.

Most importantly, at Engineered Tax Services, we’re national experts in the field of cost segregation and its tax benefits.  As a matter of fact, we’ve completed over 30,000 cost seg studies in the past 20 years and saved our clients millions of dollars in taxes.

In short, it helps to work with a savvy accounting firm.

Check Out Some of our Case Studies

Do I Qualify For A
Cost Segregation Study?

The short answer would be, yes! 

If you’re a corporation, partnership, trust, or individual with real estate purchased or built within the past 15 years with tax liabilities you can benefit from a cost segregation study.

Because a cost seg study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 or 39 years, both residential and non-residential commercial properties both qualify.

Download infographic on Cost Segregation Services Process here.

How much Depreciation can be Accelerated for my Property Type?

The application of Cost Segregation can lead to varying degrees of accelerated depreciation, depending on the specific type of property. Each property type, be it residential, commercial, industrial, or special-purpose, has unique attributes that influence the potential for depreciation acceleration. The table below presents a range of percentages, indicating the potential for accelerated depreciation applicable to each property type.

Download a PDF of the Property Reclassification Table here.

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Engineered Documentation Approaches

The cost seg specialists take the data compiled to produce a comprehensive report for the cost segregation study. To date, the IRS does not have a standard or required procedure in compiling a cost segregation study. The more detailed and accurate a study is, the faster the IRS service provider can review it so that the taxpayer may receive his or her deductions.

The IRS guide on cost segregation numerates certain methodologies that are often utilized by specialists including the detailed cost approach, the detailed cost estimate approach, the survey approach, the residual estimation approach, and the sampling approach.

The Detailed Cost Approach

The detailed cost approach compiles costs from construction and accounting records to build a report. Since this method relies on true documentation and little estimates, it is typically the most time consuming but the accurate method.

The Detailed Cost Estimate Approach

The detailed cost estimate approach is generally used for new construction. Much like the detailed cost approach, the detailed cost estimate approach will also need a compiled list of documents. However, when a record is not found the specialist will do an estimate of the cost of the component to report. In order to find these estimates, the specialist must find the cost from a reliable source and have the source referenced in the study. For this reason, it is important that the client provides all requested invoices in order to not have to depend on an estimate of a component.

The Survey Approach

For the survey approach, the specialist performs a site inspection and has all the components of the property listed. Then the cost segregation specialist will reach out to the contractor or subcontractors in written form and ask for the prices of each item. Depending on how long ago the work was done, this will dictate how reliable the data of costs will be for each component.

The Residual Estimation Approach

The residual estimation approach is a method that determines the cost of short-lived assets, such as on a 5 or 7-year property. Then these costs are added together and then subtracted from the total project cost, while the remaining price is assigned to the building itself or other long-lived assets.

The Sampling Approach

The sampling approach helps costs and resources of the study to be greatly reduced. However, sometimes the accuracy of this approach is more likely to be flawed. This method is applied by performing a cost segregation study on a sample of a large portfolio of properties. Based on those results, a standard model is developed for each facility type. The prices are then taken from the model and repositioned on a percentage basis. If you are a firm with many properties, this approach may work well for you.

Pros and Cons of Cost Segregation

ProsCons
✔️ Accelerated depreciation deductions
✔️ Increased immediate cash flow
✔️ Possibility of retroactive tax savings
✔️ Creation of detailed asset analysis
✔️ Potential for partial disposition deductions
❌ High cost of conducting the study
❌ Increased risk of IRS audit
❌ Potential for recapture of accelerated depreciation
❌ Complex study process

Concerned about potential issues associated with conducting a cost segregation study? Click here to learn more about common cost segregation concerns and their solutions.

When and How Often Should I Do A Study?

Because cost segregation sets a baseline for the original purchase, it’s easier for us and the IRS to set that baseline by performing the study before the rehab, with an engineer documenting the reclassification, before the improvements are made. It’s harder to document your rehab costs after you’ve renovated.

After the rehab, you’ll have receipts and invoices that tell us the exact cost of the new items. With your cost seg report pre-rehab and receipts/invoices to justify the cost of anything new and details on what was replaced, you’ll have everything you need to apply bonus depreciation/partial disposition elections/repair rules. If you go ahead with the improvements, you can revert back to the original cost seg studies and calculate your partial asset disposition.

If you go ahead with your cost seg study, we will:

  • Classify or reclassify each building component into the appropriate tax life as prescribed by IRS guidelines and identify
  • Allocate indirect costs to each asset, and
  • Complete a written report with the asset details supporting the reclassifications and completion of the necessary tax form(s).

In other words, after you commission your study, you can leave the driving to us. We’ll handle all the details and work with you to get the most advantageous tax break. We’re experts at cost segregation; we’ve completed over 30,000 studies in the last 20 years.

Our clients save an average of $200,000 by commissioning a cost seg study with us. You may be able to recoup more. Please contact us and see how much in tax savings we could possibly deliver to your door.

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How Do I Get Started?

How do you get started with a cost segregation study? It’s very simple: call us, and we’ll handle the rest!

Engineered Tax Services will be happy to either visit your premises or do a remote visit so that we can give you a free cost segregation feasibility study. We will:

  • Evaluate your current tax status and future business plans to determine if a cost seg study should be applied to your project
  • Evaluate the building’s construction costs by component or systems
  • Review your project’s/facility’s construction documents, including as-built drawings and project specifications
  • Visit the facility/project or provide virtual Tele-Engineering™ services to determine and identify how the components and systems are utilized – as well as to document the systems and components
  • Provide a detailed engineering review of the assets, including special purpose mechanical and electrical systems, decorative finishes, site improvements, and any process related to special purpose construction
  • Classify or reclassify each building component into the appropriate tax life as prescribed by IRS guidelines
  • Identify and allocate indirect costs to each asset
  • Complete a written report with the asset detail supporting the reclassifications and completion of the necessary tax form(s)

Is it more advisable to undertake a cost seg study before or after a construction rehab? Our advice is: do it before any improvements.

It’s better for the IRS to see the cost segregation study before the improvements are made. It is harder to document later, if you don’t do it before rehabbing the property.

Cost segregation is setting a baseline for the original purchase. Doing the study before the rehab makes it easier for us and for the IRS to set that baseline, with an engineer documenting the reclassification.

After the rehab, you’ll have receipts and invoices that tell us the exact cost of the new items. With your cost seg report pre-rehab and receipts/invoices to justify the cost of anything new and details on what was replaced, you will have everything you need to apply bonus depreciation/partial disposition elections/repair rules. If you go ahead with the improvements, you can revert back to the original cost seg studies and calculate your partial asset disposition.

Original post from Engineered Tax Services can be found here.

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One Comment

  1. Cost segregation analysis is undoubtedly a game-changer in real estate tax strategy. By breaking down property components for tax purposes, it unlocks significant savings and maximizes depreciation benefits. It’s crucial to partner with the best cost segregation companies to ensure accurate assessments and optimal tax benefits. In Pennsylvania, cost segregation firms offer invaluable expertise, helping investors navigate complex tax laws effectively. Leveraging cost segregation services can lead to substantial savings, making it a smart investment for any real estate owner.

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