Understanding Cost segregation

Cost segregation is an area of the tax code often overlooked by smaller (and even larger) real estate investors, funds, or businesses in general. I will explain these concepts as they relate to those who own rental income properties, since these are the most common taxpayer types reaching out for assistance. However, these exact concepts also apply to businesses that have any type of larger capital assets, such as manufacturers, those owning warehouse or office space, those purchasing facilities with various components, etc. 

The basic concept is that each business use asset may have more than one component and each component may have its own measure of “useful life” for depreciation purposes.

For instance, a residential rental home we all know is depreciated over a life of 27.5 years as per the current US tax code. However, the roof of this home has a useful life of only 5 years. The refrigerator has a life of 7. The electrical breakers 10. 

This presents an opportunity for accelerating depreciation. Rather than getting the tax benefit over 27.5 years for the entire investment, we can depreciate certain components faster. 

What advantage does this have? If I have a property showing a profit but want to reduce this taxable profit, accelerating deprecation may do the trick. This is the major “pro” here.

What are the cons? A few are listed below:

• Cost of the study is a con. There are many companies offering engineering “studies” called “cost segregation studies” as a service – many of these are not necessarily accountants or engineers – these label themselves as cost segregation specialists & other similar titles. They have a hard sell approach to purchasing this type of engineering study with the explanation that the work is very complex. They charge thousands & the end product is an actual glossy PDF or file that breaks out the components for purposes of including the new depreciable lives into your tax return. Some go as far as preparing portions of the return that have to do with the depreciation. The concept here is that the work was completed professionally and you have backup in case of and IRS audit. However, this type of study is not really necessary – you can simply use accelerated depreciation concepts on your own return. Part of the hard sell is that this has huge IRS audit risk, but in reality, our representation practice rarely receives support requests for any work related to depreciation. Actually, out of over 2,200 clients, I cannot think of a single such request in over a decade 
• Another con has to do with the ability to take this deduction in the first place – most clients that own property use it as passive income & have a full-time job elsewhere. For those who are not “qualified real estate professionals (and this is another topic altogether requiring its own article)” you can only deduct passive rental losses, such as deprecation, up to the extent of income. This means that even if you accelerate your depreciation, you cannot obtain an immediate tax effect if you do not have more passive renal income to absorb this loss. This is a complex topic related to passive unallowed activity losses. I will explain further below:
  •  If you earn over $150,000 from other income sources and your modified adjusted gross income is over this threshold, your ability to take losses on renal real estate is limited to the amount of income from such real estate
  • However, you do “lose” additional losses; they are simply carried forward until you either 1. sell the property or 2. show gains elsewhere
  • That said, why accelerate if you can’t use it anyway? 

Conclusions: 

For business owners or those who are in the real estate business as “qualified real estate professionals,” you can take these losses right away, so don’t hold back! 

For more information, please contact Dimov Associates at the contact below. We are more than happy to assist.