Cost Segregation: The Secret That Savvy Investors Use to Minimize Their Taxes

Cost Segregation: The Secret That Savvy Investors Use to Minimize Their Taxes

Savvy real estate investors often focus their efforts on minimizing their tax liability by taking advantage of certain tax strategies that are within our tax laws. A Cost Segregation Study (CSS) is an engineer-based study of all of the individual assets purchased in a real estate transaction. Rather than a lump sum depreciation schedule, the taxpayer uses an accelerated depreciation schedule via “segregation” resulting in higher tax deductions in the early years of the purchase of a property — keeping more dollars in the business.

A CSS can be the difference between a successful real estate venture and a failed one or can help to expand the strategic implications of a growing portfolio. No matter where you are in your investment journey, utilizing a CSS could generate the right data needed for you to maximize your investment potential.

How does a cost segregation study work?

When you purchase or build a commercial property, it depreciates straight-line over 39 years (27.5 years for residential rental properties).

However, the property is actually made up of many components, some of which can be depreciated over a shorter time period.

A cost segregation company generally follows the following process:

  • Identify and quantify each component
  • Allocate the total cost of the building across all the components
  • Reclassify each component according to the law, based on the facts and circumstances
  • Assign shorter tax lives accordingly
  • Recompute the accelerated depreciation to date, to defer tax liability

Who should consider a cost segregation study?

As cost segregation studies can cost between $7,000-$15,000, these studies are not for every property.  They are typically used by commercial real estate investors or rental property owners with significant real estate holdings.   If your portfolio is not generating a substantial income or the tax savings a CS would provide would not exceed the initial cost, it is not likely that such a study is right for you.

What should you be looking for in a Cost Segregation firm?

Reputable firms will be able to detail with you their process and credentials When interviewing potential companies, the Internal Revenue Service suggests 13 principle elements that investors should consider They are:

  1. Preparation By An Individual With Expertise and Experience
  2. Detailed Description Of The Methodology
  3. Use of Appropriate Documentation
  4. Interviews Conducted With Appropriate Parties
  5. Use Of A Common Nomenclature
  6. Use Of A Standard Numbering System
  7. Explanation Of The Legal Analysis
  8. Determination Of Unit Costs And Engineering “Take-Offs”
  9. Organization Of Assets Into Lists Or Groups
  10. Reconciliation Of Total Allocated Costs To Total Actual Costs
  11. Explanation Of The Treatment Of Indirect Costs
  12. Identification And Listing Of § 1245 Property
  13. Consideration Of Related Aspects (e.g. I.R.C. § 263A, Change in Accounting Method And Sampling Techniques)

When should a cost segregation study be engaged?

Most tax professionals suggest completing a CSS immediately after the purchase, significant construction (remodel, expansion, etc.) within the first 12 months of such an event to help maximize the benefits.

If you feel that a segregation study may benefit you, make sure you contact your tax professional and work with a qualified cost segregation organization to ensure the study is in compliance with the current standards and audit techniques provided by the IRS.