In this summary, we cover:
- What cost segregation is
- The benefit of cost segregation
- Why the IRS prefers the engineering approach for cost segregation
- Cost segregation helps you to identify assets and their related costs, and then reclassify such assets for the purpose of tax preparation.
- Under cost segregation, asset costs can be reclassified leading to the acceleration of depreciation on such properties—investors can, therefore, increase their income tax deduction leading to a lower taxable income.
- The cost of conducting a cost segregation study is usually allocated to every investor—be sure to adequately communicate every detail of the study to them.
- At the acquisition or construction stage of a property, a cost segregation study can be conducted and effected in the initial tax period. Additionally, the IRS currently allows investors to conduct a cost segregation study on real estate properties utilized in the prior year and ‘catch up’ the extra depreciation when filing a change in the accounting method with the tax return.
- The IRS prefers the engineering-based approach towards conducting a cost segregation study.
Cost segregation entails identifying assets and their costs and classifying those assets for federal tax purposes.
Costs segregation plays an important role in unearthing potential tax savings and improves cash flows through reclassification and depreciation of property.
The IRS and other stakeholders consider the engineering-based cost segregation study as the best means of accounting for fixed assets such as buildings, accelerated depreciation, and disposition of assets.
A number of investors in private real estate funds or partnerships consider the taxable income from their investment activities a given. Nonetheless, partnerships and fund managers can set up efficient tax planning strategies to reduce the tax burden of investors. One such strategy is Cost Segregation.
Rather than the conventional depreciation period of 27.5 or 39 years for assets relating to buildings or acquisition costs, cost segregation advocates for depreciating certain assets in real estate over 5, 7, or 15 years. These assets will then have their associated costs reclassified; allowing the owners to accelerate the depreciation of that particular property for tax purposes.
Subsequently, such an investor will be able to have an increase in income tax deductions—also, the property-level firm will have cash flow savings through a reduction of the distributable income for investors’ tax liabilities.
A decent number of investors set up real estate ventures as flow-through entities; reporting taxable incomes from such ventures on the Schedule-K-1. Much property–level agreements require cash distributions to be able to cover the tax effect on these properties. Through a cost segregation study, the required distribution could be lowered substantially.
With the use of a cost segregation study, a firm can be able to record a lower taxable income attributable to investors during the first 15 years of property ownership due to accelerated depreciation deductions. As a result, the accelerated tax deductions will be able to provide huge savings over the useful life of the property.
Let’s consider the passive income activity loss rules for individual investors. Essentially, if an investor is not an active participant in the operations of a property, then any such real estate net losses reported can only be deducted from the income from all other passive investments owned by such an investor.
Every situation is unique and may require the engagement of an advisor. With a cost segregation study, the excess deduction attributed to a particular investment could be prevented. But if this happens, the deductions won’t be lost—any such losses are carried forward and may be used to offset future real estate incomes reported by the firm.
Point to note: Cost segregation is an essential tax planning weapon—and this should adequately be made known to investors. The cost segregation approach could lead to a disparity between the financial statement’s net income for tax-returns purposes and the reported net income statement. The difference should clearly be communicated to investors before a cost segregation study can be undertaken. Further, the cost of conducting a cost segregation study would generally be allocated across all investors’ incomes—proper prior communication will go a long way in preventing any potential disagreements.
A cost segregation study can be conducted to all properties that have been purchased, improved, expanded, or constructed for rental residential or commercial real estate. A great example would be a property improvement or building worth more than $500,000 or $1,000,000 respectively.
All types of properties including hospitals-related, warehouses, manufacturing buildings, and so on may qualify for tax benefits resulting from cost segregation. This is despite a cost segregation study being dependent on the individual property and taxpayer.
During any stage of a property (at acquisition or construction), cost segregation can be performed and effected in the initial tax period. Currently, the IRS permits investors to perform a cost segregation exercise on real estate properties put to use in a prior year and ‘catch up’ the extra depreciation. The benefit will be captured when filing a change in the accounting method with the tax return where the caught-up gain gets reported. This means that you won’t need to file an amendment of your tax returns.
As mentioned earlier on in this article, the IRS prefers the engineering-based cost segregation approach. Under this approach, the study will, therefore, include physical property inspection, evaluation of engineering drawings, examination of designs by the architects, reviewing the cost-related data such as payments application by the contractors, indirect disbursements, and so on.
The process will lead to the generation of a list of items of each property unit that fit to be classified for shorter periods. Based on the data collected and reconciled, the capital cost of a property will be established and indicated on the fixed asset schedule of the property.
The documents derived from this exercise are usually recognized not only by the IRS but also other relevant tax bodies.
We hope you found this piece to be useful towards understanding the impact of Cost Segregation in relation to the real estate sector in the US. However, we know too well how this could be overwhelming so if you require any further assistance, be sure to reach us for a more customized solution.