If you’ve got real estate or real estate clients, you should know that the best way to reduce tax liability is by commissioning a cost segregation study. But should you do it before or after a rehab—or both?
The Importance Of A Cost Segregation Study
The IRS, in its 1999 memorandums, defined cost segregation by recognizing that a building consists not only of walls, roof, and interior rooms, but also land improvements (storm sewers, curbs and sidewalks, parking lots, swimming pools, landscaping, etc.) and personal property (flooring, interior finishes, decorative lighting, kitchens, interior glass and electrical wiring for appliances, etc.). This helped clients accelerate depreciation of their buildings.
The memorandums clearly stated:
- a typical property’s structure is subject to a 39-year recovery period;
- land improvements are subject to 15-year recovery period; and
- certain other building components qualify as personal property with a five-to-seven-year recovery period.
Today the IRS allows the componentization of buildings for accelerated tax depreciation via a cost segregation study to identify land improvements and personal property that can be separately depreciated over the shorter recovery period. As a result, the average commercial building owner will realize approximately 25 to 95 percent of their building’s total costs as shorter class-life depreciable assets, depending on the asset type. This can result in major tax savings and increase cash flow for smart real estate investors.
As an added benefit, the cost segregation study may open the door to bonus deprecation, which means you don’t have to wait 5, 7, or 15 years for depreciation class lives to kick in; you can take all the reclassified items in year one.
When Should I Undertake My Cost Seg Study?
Every day I’m asked whether it’s more advisable to undertake a cost segregation study before or after a construction rehab. My 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 exactly what the cost is 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 the client goes ahead with the improvements, they can revert back to the original cost seg studies and calculate their partial asset disposition (PAD).
What is a Partial Asset Disposition?
It’s a deduction that allows property owners to recognize a loss on the disposition of a portion of a building, which generally occurs when they make significant improvements to the building, which include replacing, disposing of, or ripping out existing building components. It’s part of the Tangible Property Regulations (TPR) released in 2013 that overhauled how businesses decide to expense or capitalize property improvements and purchases.
Additionally, doing a cost segregation on the original purchase will yield considerable tax savings. Many of the improvements may qualify for an immediate write-off as qualified improvement property (15-year QIP) and may not have to be capitalized. Another great benefit to cost segregation studies is the fact that bonus depreciation applies to any property classified to a bucket of 20 years or less, which includes QIP.
In closing, I strongly recommend getting a cost segregation study conducted on a property before rehab work is done. It gives you a clear baseline for your property value, and the tax benefits are very tangible.