Using Cost Segregation Studies To Tax Advantage

Written by admin on May 23rd, 2011


• recent appraisal of the property (if available);

• recent property tax bill;

• historical cost information, including: final general contractor’s payment application; fixed asset schedule/tax depreciation schedules; inventories of furniture, fixtures and equipment;

• property manager contact person.

Utilizing these records and the physical review of the property, a cost segregation company will make a determination as to what should be considered real property depreciable over 27.5 or 39 years, or personal property depreciable over five, seven or 15 years. A report is generated using either actual construction costs from the document review, or historical costing data to establish values for the personal property contained in the building.

The IRS has stated that an “accurate cost segregation study may not be based on non-contemporaneous records, reconstructed data, or taxpayer’s estimates or assumptions that have no supporting records.” IRS Letter Ruling 199921045. It is important that a cost segregation study be performed utilizing actual data from the subject property, and not in a “cookie cutter” fashion where data from similar-type properties, such as chain restaurants, are aggregated to establish a cost segregation report. The IRS has made it clear that it is the taxpayer’s burden to prepare an accurate and well documented cost segregation study.

Application of the Study

Once the cost segregation study is prepared, it is utilized by the taxpayer’s accountant to prepare a tax return using the new classifications. However, a cost segregation study’s benefits can be both prospective and retrospective.

If a property is newly acquired and placed into service, or if new improvements are completed and placed into service, the benefits of a cost segregation study will be for the current and future tax returns. However, for property or improvements already in service where IRC § 1245 property has not been segregated from IRC § 1250 property, there is the additional opportunity to “catch up” on this missed depreciation.

The benefit of restating past depreciation is the opportunity to recoup the benefit of the missed depreciation all at one time. Often this results in the added benefit of recouping an amount that is multiples of any cost of performing a study. However, in most cases it will be necessary to file a request for change in accounting method with the Internal Revenue Service pursuant to Rev. Prov. 2002-9, which provides for an automatic consent procedure for taxpayers who have claimed, among other things, less depreciation than allowable.

Recent Additional Benefits

The Job Creation and Worker Assistance Act of 2002 (2002 Job Act) provides for an additional 30 percent first-year depreciation deduction for certain qualifying property acquired after Sept. 10, 2001 and before Sept. 11, 2004, under the newly added IRC § 168(k). For real estate investors, the 2002 Job Act provides a tremendous opportunity to realize much greater present day saving by more rapidly depreciating items such as qualified leasehold improvements (IRC § 168(k)(3)), and property that has a depreciable life of 20 years or less under MACRS.

In addition, the Jobs and Growth Tax Relief Reconciliation Act of 2003 expands and modifies the bonus depreciation provisions of the 2002 Job Act. The 2003 Act allows taxpayers to elect additional first-year depreciation of 50 percent for qualified property, as defined under the 2002 Job Act. The original use of the property must commence with the taxpayer after May 5, 2003, and the property must be acquired by the taxpayer after May 5, 2003, and before Jan. 1, 2005, and be placed in service before the latter date. The 2003 Act also provides a clarification that provides that the adjusted basis of qualified property acquired in an IRC § 1031 tax deferred exchange or an involuntary conversation is eligible for the additional first-year depreciation benefits.

A cost segregation study takes on additional importance as it can segregate property that would qualify for the benefits of the 2002 Job Act from the specifically excluded 27.5 year residential rental property and 39 year nonresidential property. Furthermore, a taxpayer qualified for the benefits of the 2002 Job Act but who has already filed a tax return without claiming the benefit can revise the previous year’s returns.

The Bottom Line

Too often, investors in real estate fail to take into consideration the tax consequences and benefits of their investments. Many times the combination of real estate property taxes, depreciation deductions, and capital gains taxes due upon the sale of the property can have a significant effect on the profitability of an investment. In some cases, the failure to recognize the role that taxes play in the investment can even result in a loss to the investor.

A cost segregation study is another tool at the disposal of real estate investors to help make sure that their investments remain profitable. As always, however, it is important to consult a tax professional to discuss options available before an acquisition, during the period of ownership, and upon a contemplated disposition of the property.

Todd R. Pajonas is the President of Legal 1031 Exchange Services, Inc., a national qualified intermediary for IRC §1031 tax deferred exchanges.

Legal 1031 Exchange Services, Inc.





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