The 6 Levels of Cost Segregation Methodology Recognized by the IRS

     Real Estate Investors who acquire, construct, or rehab/renovate commercial real estate property (residential rental or income generating commercial property) can realize significant tax saving and increased cash flow via an engineered cost segregation study.  

WHAT IS A COST SEGREGATION STUDY?

     Cost segregation is a tax planning strategy of FRONT-LOADING qualified depreciation for a commercial property or residential rental property (including apartment complexes, rental homes, and Air BNB’s).

     This allows you to REDUCE your federal income taxes and KEEP MORE OF YOUR MONEY in your business or your bank account instead of sending it to the IRS.

     Significant savings are hidden in the walls, floors, ceilings, parking lot & landscaping. Certain components previously classified with a 39 year or 27.5 year life, can be re-classified as personal property or land improvements; applying a 5, 7 or 15-year depreciable life utilizing cost segregation.

Benefits of Cost Segregation:

• An immediate increase in cash flow
• A significant reduction in current federal tax liability
• The ability to reclaim "missed" depreciation deductions from prior years (without having to amend tax returns) 

     In response to the increasing popularity of cost segregation studies, the IRS developed the Cost Segregation Audit Techniques Guide to provide guidance to tax professionals. The Audit Techniques Guide provides an overview of what cost segregation is, as well as guidance on what makes a quality cost segregation study. They list the 6 most accepted methodologies of cost segregation.

     Our ”Fully Engineered and Accounted” methodology is the highest level of study defined by the IRS. This methodology will account for ALL qualifying (5-, 7- and 15-year items) and non-qualifying (39 year or 27.5 year items) including wiring, plumbing, and conduit.  It also provides the client with a fixed asset tool.  This methodology will provide the most tax benefit and also the most audit protection. The first two methodologies are “Fully Engineered and Accounted”. 

     There are four (4) other methods and study types that incorporate less/no engineering. These are:

1)   Survey

2)   Residual Estimation

3)   Sampling/Modeling

4)   “Rule of Thumb” approach

     These studies are often called ‘engineering-based’ and commonly performed by a ‘qualified’ practitioner, perhaps an engineer. Some use software only to estimate costs, and some parts of these studies may be contracted out to third parties, even in other countries.

     As a result, these do not detail each and every building component. The straight-line assets are bundled together. Thus, they tend to leave a portion of the owner’s money on the table. You will see anywhere from 5% to 15% less deprecation benefit when you use these lesser study types. They also can cause scrutiny in the event of an audit.

     Methodology matters. Do you homework before choosing a cost segregation firm!

     Without Cost Segregation, rental/residential real estate is depreciated over a 27.5-year life, and other commercial real estate depreciates over a 39-year life. Reclassifying components into shorter depreciable lives of 5, 7, or 15 years are what creates this accelerated depreciation, to generate substantial current year tax deductions.

SO, WHAT DOES THIS REALLY MEAN TO TAXABLE INCOME?

     A shorter depreciable life means more tax deductions NOW. More tax deductions mean a reduction in taxable income. The reduction in taxable income equates to more cash in your pocket.

     The Journal of Accountancy states: “Cost Segregation is not a tax shelter.  It is a specifically defined and guided I.R.S. tax reduction tool.  Ninety percent (90%) of all commercial property investors are overpaying their federal income taxes.”  

LET’S LOOK AT TWO 2020 CLIENT EXCELLENT EXAMPLES OF FULLY ENGINEERED TAX STUDIES PERFORMED BY ELB CONSULTING.

CLIENT A – MULTIFAMILY ACQUISITION:

     Client A acquires an Arizona apartment community for $2,500,000. Using a land allocation (the raw land is not depreciable) of $500,000, the depreciation basis is $2,000,000. If using the 27.5 year straight-line depreciation, the tax deduction would be $72,727 per year. However, Client A decided to engage us to perform a cost segregation study. The Cost Seg America team was able to identify $1,058,916.30 of the asset costs to be reclassified over 5, 7 and 15 years (53% of the depreciable basis). By utilizing this study and electing 100% Bonus Depreciation, the client has gone from a $72,727 deduction in year one, to $1,058,916.30deduction in year one. This contrast is substantial!

CLIENT B – FREE STANDING RETAIL ACQUISITION

      Client B acquires a Colorado two (2) premium tenant retail building $2,000,000. Using a land allocation of $400,000, the depreciation basis is $1,600,000. If using the 39 year straight-line depreciation, the tax deduction would be $41,026 per year. Client B also decided to engage us to perform a cost segregation study.  The Cost Seg America team was able to identify $747,496.46 of the asset costs to be reclassified over 5, 7 and 15 years (47% of the depreciable basis). By utilizing this study and electing 100% Bonus Depreciation, the client has gone from a $41,026 depreciation deduction in year one, to $747,496.46 depreciation deduction (or passive loss) in year one. Client A is a Real Estate Professional, so this significant tax deduction was used against ordinary income.

     Ultimately, cost segregation is tax strategy that improves cash flow and capitalizes on the time value of money.  Call us for a free evaluation today, or submit your proposal request online here FREE PROPOSAL.