accountants’ top five questions answered.
by brian coddington
source advisors
brian coddington is the director of tax accounting methods and credits in the fort worth, texas, office of source advisors.
cost segregation is a highly beneficial and widely accepted tax compliance strategy utilized by commercial real estate owners and tenants to accelerate depreciation deductions, defer tax and improve cash flow.
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1 — who uses cost segregation?
once used only by the largest accounting firms and real estate owners, this practice has now become routine for commercial property owners of almost every size.
not only is cost seg one of the most effective tax strategies for real estate owners and investors, it has become one of the top niche services for accounting firms.
further, cost seg can be used for all types of property – not just for newly constructed or newly acquired assets – and it can dramatically increase your cash flow.
2 — when should a cost segregation study be performed?
there are several situations where a cost segregation study should be performed.
a cost segregation study should be performed immediately after construction or acquisition or following major capital improvements (including leasehold improvements).
the analysis can also be performed after a change in ownership, including inherited property and a change in partnership interest.
and finally, a cost segregation study can be useful for buildings already in service. in this situation, a look-back study would be performed.
the irs permits taxpayers to use a cost segregation study to adjust depreciation on properties placed in service as far back as jan. 1, 1987.
many property owners and tax advisors share a common misconception that once the three-year statute to amend has expired, the taxpayer can no longer make a change.
fortunately, this is not the case. upon completion of the study, the taxpayer is allowed to make an adjustment under irc §481(a) to catch up on depreciation.
the catch-up, which is taken in a single year, is equal to the difference between what was depreciated and what could have been depreciated if a cost segregation study was performed on day one.
expectedly, these benefits can be quite substantial. as a bonus, the change can be made without filing an amended return. the taxpayer simply files form 3115 (change in accounting method).
3 — who benefits the most from cost segregation?
you can seriously benefit from a cost segregation study if your building or improvements were placed in service since 1987, but most studies are limited to the last five to seven years.
you can also benefit if your building or improvements are currently depreciating over 27.5 or 39 years.
if you have over $1 million in capitalized costs, it’s good to begin thinking about cost segregation.
ideal building types include apartment complexes, auto dealerships, banks, casinos, distribution centers, grocery stores, health care facilities, hotels, manufacturing facilities, nursing homes, office buildings, restaurants, shopping centers, sports facilities, warehouses and other specialized property types.
typically, the more complex buildings will generate the greatest benefit from a cost segregation study. it’s important to note that the property owner must be a tax-paying entity.
4 — how cost segregation fits into estate planning
a cost segregation study can enhance the estate planning process by lowering the property owner’s tax burden.
two key benefits of using cost segregation in an estate plan are
(1) acceleration of depreciation and
(2) avoiding potential recapture.
both have a significant and positive impact on cash flow.
typically, after a death in the family, the heirs’ tax-planning efforts focus on how the assets will be distributed and what impact it might have for them.
many people can overlook valuable opportunities that exist to reduce the deceased’s final income tax liability. a cost segregation study can be used to claim missed deductions on the deceased’s final income tax return.
the study also helps avoid depreciation recapture, which gets wiped out in the basis step-up upon death. this increases the estate amount available to the heirs.
5 — will using cost segregation increase the risk of an irs audit?
no. you are at no greater risk with new assets (acquisition or new construction) than you are in filing any income tax return.
additionally, the general feeling throughout the cost segregation industry is that the irs has been getting a bit more aggressive about the review of cost segregation studies; specifically with respect to the methodologies being used and the qualifications of the preparer.
per the irs audit techniques guide, studies being performed by unqualified individuals and those using an abbreviated methodology will receive higher scrutiny than the ones performed by qualified professional who utilized the detailed engineering-based approach.
therefore, it is more important than ever to have your studies performed by an expert in the field.