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Cost Segregation- impacts on your bottom line

by Sunny Kancherla

Cost segregation is becoming a hot topic for residential real estate owners, but the question remains: is it worth it? The answer, in short, is absolutely. If you are not familiar with the idea of cost segregation, the basic concept is to divide your real estate holding into different component pieces and depreciate them on shorter schedules than the current 27.5 years allowed by the IRS. Authors Douglas S. Bible and Stanley Hays mentioned in their article, Cost Segregation and Real Estate Investment Returns, “Based on the different lives assigned by the Modified Accelerated Cost Recovery System (MACRS), and the different treatments for depreciation recapture specified by Sections 1245 (depreciation of tangible personal property) and Section 1250 (depreciation of real property), it is evident that Congress intended to distinguish between real property and tangible personal property, effectively allowing the use of cost segregation.” But there is one catch. The IRS requires ACCURATE cost segregation studies performed by engineers or architectural firms to document the segregated depreciation components. This documentation can cost a considerable amount upfront, but depending on the size of your property, this investment can yield significant returns over the life of your property. Segregating the pieces of your property can be tricky. Structural components are not eligible for a personal property classification. Structural property, as defined by Reg. 1.48-1 is property that “relates to the operation or maintenance of a building.” This may include things like walls, floors, ceilings, windows, doors, central air conditioning, electrical wiring, plumbing and fixtures, and sprinkler systems among other things. Items like these must be depreciated over 27.5 years (39 yrs for commercial). On the other hand, non-structural components can be eligible for depreciation over a five or seven year schedule. According to Bible and Hays, guidelines that help engineers determine the eligibility include questions like “whether the property can be moved, how difficult it would be to remove I, whether it is designed to remain permanently in place, and whether there are circumstances that tend to show the intended length of affixation.” One of the challenges that exist is that “Since the IRS has provided no specific standards for cost segregation studies, they vary widely with no standard methodology applied. The IRS notes that this lack of consistency and the complexity of the law often require IRS examiners to request assistance from specialist such as engineers, computer audit specialists, and technical advisors,” say Bible and Hays. Still, the reason why cost segregation is so powerful is that it allows you to recognize more depreciation in earlier years. Since expensing costs earlier in its life provides earlier savings, depending on your tax bracket, this can significantly increase your after tax-rate of return.

As you can tell, this is a relatively easy concept to grasp; however the implementation takes considerable time and investment. Before jumping in with both feet, you should consult your tax advisor to get more information on this approach and find out if cost segregation is a viable strategy to apply to your portfolio.