Cost segregation and benefits to your clients

The acquisition and renovation of commercial and residential real estate is often the largest expense for the average client. In this context, cost segregation is an often-overlooked path to financial relief that clients can benefit immensely from. Through maximizing deductions, a client can minimize their federal/state tax burden, freeing their money for reinvestment elsewhere.

Who can benefit

Any client who has purchased or built investment real estate in the past 15 years can benefit from a cost segregation study. Long-term investors who want access to more funds will benefit the most, because benefits increase the longer a property is held—meaning more tax years to deduct.

Cost segregation requires a team of engineering and financial experts. While studies are not free; they usually cost $5,000 to $15,000 each, so savings over time usually outstrips the one-time fee.

Tax preparers also can benefit, as most cost segregation companies will offer a referral fee. Cost segregation companies rely on tax preparers as their “trusted advisor” and see the value in providing a referral fee for introductions and closed deals.

What is it?

Cost segregation differentiates between the short- and long-term aspects of a given property. For example, residential rental and commercial properties depreciate over the course of several decades: 27.5 years and 39 years, respectively. This depreciation can be deducted against the owner’s taxable income.

However, there are numerous elements such as the sidewalk, fencing, carpet, or plumbing that depreciate much faster over 5-15 years. These assets can qualify for bonus depreciation, which can provide some immediate expense in the year the assets are placed in service. Without cost segregation, these shorter-lived elements are written off with the same, longer schedule of the property as a whole. But a cost segregation study allows a client to identify the parts of a property that depreciate faster, allowing for larger deductions on parts with faster depreciation.

A cost segregation study begins with a feasibility analysis; the team analyzes and categorizes parts of the property, including wiring, lights, flooring, renovations, and plumbing, evaluating if it is a good candidate. This is usually accompanied with a formal appraisal, as well as an in-­person examination of closing documents signed on purchase, inspection records, property records, and blueprints. Any operating costs that can be depreciated over 5-15 years are then identified and outlined in a formal report, and provided to the client and the tax advisor at closing.

When should a study be conducted?

A cost segregation study can be conducted any time after your client buys, builds, or remodels a property. However, the best time is the same year of purchase, construction, and/or remodeling, because the highest savings occur in years when the most money is spent. However, a look-back study can also be conducted, catching up the difference between the originally claimed depreciation and what could have claimed if the study were performed earlier. These deductions occur in a single year, and the taxpayer will need to file Form 3115, Application for Change in Accounting Method, to catch up the depreciation in a current year.

What to look for in a cost segregation company

While rare, it’s important to find a cost segregation company that will offer audit support in case the IRS wants to delve deeper. In addition, the cost segregation company should clearly provide a methodology for conducting their study and also be a reputable company. There are many “low cost” cost segregation companies that do not do their due diligence in substantiating client’s depreciation deduction. At minimum, the cost segregation companies should be able to do a physical inspection and take pictures of the property so there is proper documentation for the report in case of an audit.