At Simple SEG, we spend a lot of time talking with real estate investors (both large and small) about cost segregation studies. In many situations, investors are looking for increased tax deductions. But they just don’t understand how cost segregations work and many just don’t want to spend the money on the study.
Basic depreciation is great. But the problem is that if you want the added depreciation benefits association with a new property the cost segregation study is your best option.
Another big concern of investors is their tax bracket. The top tax rate has been reduced recently but it is still at 37% (plus any state taxes). Many investors find themselves giving a big chunk of their income to the IRS. Tax planning drives many real estate investors to research the benefits of cost segregation studies.
But cost segregation studies actually come in many shapes and sizes. Investors with a few properties may find some solutions more beneficial than large investors. In either case, we are going to take a close look at tax strategies and what options are available.
Cost Segregation Tax Reform
The passage of Tax Cuts and Jobs Act (TCJA) bill gave real estate investors more reasons to conduct a cost segregation study. TCJA has cost recovery provisions that allow a taxpayer in the real estate industry a chance to plan and take advantage of tax saving opportunities.
The Act directly involves cost segregation. For instance, there is 100% bonus depreciation for qualifying property acquired and placed in service after September 27, 2017. Qualifying property has also been expanded to include used property.
The TCJA provides for an accelerated tax deduction for constructed or acquired real estate, whether commercial or residential. This is done by reallocating purchase or construction costs to qualified property classified by cost segregation study. Qualifying costs can, therefore, be deducted in the year they are placed in service.
Bonus Depreciation
TCJA bonus depreciation is extended through 2026 for qualifying property, those with 20-year or less recovery period under MACRS and fulfill all the requirements under Sec. 168(k)(2). Bonus depreciation is applicable as follows:
- 100% for property acquired and placed in service after September 27, 2017, and before January 1, 2023;
- 80% for qualified property placed in service before January 1, 2024;
- 60% for qualified property placed in service before January 1, 2025;
- 40% for qualified property placed in service before January 1, 2026; and,
- 20% for qualified property placed in service before January 1, 2027.
A taxpayer can, however, opt out of the bonus depreciation just like in the previous tax law. The taxpayer can also elect to use a 50% and not 100% bonus depreciation rate for the first taxable year ending after September 27, 2017.
Section 168(k)(2) is also amended to expand the definition of qualifying property to include used property. The property should, however, be used for the first time by the acquiring taxpayer and it should be acquired from a non-related party. Real estate investors, therefore, have more reasons to conduct a cost segregation study on acquired property and assign parts of the property to the appropriate recovery classes.
Prior to TCJA, the used property could only be granted a short recovery period, bonus depreciation was reserved for original properties. Used property under the new law is bonus eligible and a taxpayer can expense it at the time the property is placed in service.
Qualified leasehold improvements, qualified retail improvement property, qualified restaurant property, and all other qualified improvement properties under PATH Act are all categorized under qualified improvement property (QIP), applicable to property placed in service after December 31, 2017. 100% bonus depreciation is allowed for QIP with a recovery period of 20 years or less.
Cost Segregation Tax Strategy #1: Reduce Immediate Taxes
Maximize tax savings by adjusting the time line of deductions. When an asset’s “life” is shortened, depreciation is accelerated and tax payments are decreased for the early years of a property’s life. This, releases cash for investment opportunities or funding for operating needs.
Cost Segregation Tax Strategy #2: The “Look Back”
Many investors don’t realize that segregation studies can even provide big tax savings for real estate placed in service in previous years. Studies can be implemented to “look-back” on previous years and identify personal property and land improvements that can qualify for a shorter life.
The prior tax returns can be amended to take advantage of the look-back. But, in many situations, a cumulative adjustment can often be taken on a subsequent filed return. Assuming you meet the qualifications, the IRS will allow a change of accounting method. This would be reported filed on Form 3115.
Cost Segregation Tax Strategy #3: The “Write-off”
Many segregation studies will even break out the components of the 27.5 and 39 year life assets. Even though these assets are not subject to accelerated depreciation, when they are improved at a later date the remaining book balance of the asset can be written off.
When renovation work is performed, you can take a tax deduction for the remaining book value of items removed resulting from a renovation performed. A cost segregation study can assist in helping identify the original cost of the assets that have been removed, if not previously identified.
Taxpayers can get immediate retroactive savings on property “built” since 1987. The opportunity to recapture depreciation in one year presents an opportunity to have retroactive cost segregation studies on older properties; Increase cash flow in the current year.
Cost Segregation Tax Strategy #4: The “Gain Reduction”
So let’s say that you are selling a rental property and will have a $100k gain. If you are a passive investor and subject to passive loss rules, then a cost segregation study might be a huge help.
The $100k gain that you have can be offset by passive losses. This is a great opportunity to have a study done and accelerate some immediate depreciation deductions. This depreciation will typically be allowed to offset gains from the sale of the rental property or another interest in a passive activity that is disposed of for a gain.
The gain typically will not be considered passive if, at the specific time of the disposition, the property was used in an activity that is not considered a passive activity in the specific year of disposition.
Understanding rules surrounding passive activities can be challenging. If you are not a real estate professional and think you might have passive activity loss limitations make sure to discuss it with your CPA.
Cost Segregation Tax Strategy #5: The “Step up”
Many real estate investors and CPAs alike fail to understand how a cost segregation study can be a great planning tool for an estate. When someone passes away, the assets receive a step-up in basis for tax purposes. As a general rule, no gain is recognized on inherited real estate and the beneficiary receives the property at a tax basis equal to fair market value (FMV) on the date of death.
Much focus is placed on the step up basis, but many don’t consider the opportunity to manage the assets before the person passes away. A change to the property’s basis can be done after a death occurs, but it must be completed before the filing of the decedent’s final individual tax return.
One of the best ways to lower a federal and state tax burden on a recently deceased taxpayer’s estate is by completing a cost segregation study of the original pre-stepped-up basis of the property the decedent owned.
For example, let’s assume an elderly husband and wife acquired a rental property in 2005 with a building basis of $2 million. In 2010, they had a cost segregation study performed on the same property that resulted in approximately 15% of the cost basis being reallocated to five-year tangible property. This process was able to generate a Section 481(a) adjustment of approximately $250,000 that was used to offset certain passive income from this rental property and other rental activities.
In 2011, the husband died and the wife received a step-up resulting in a new basis of $3 million. A second cost segregation study was completed and the wife received approximately $350,000 of additional depreciation deductions over the next five years. As a result of the two cost segregation studies to this point, there are approximately $600,000 of deductions that are not recaptured through gain on sale.
When the wife dies in 2018, the property is inherited by the children and the property receives another step-up in basis to $4 million. The children then complete a third cost segregation study and identify $700,000 of five-year property.
Without the studies, the building would have produced approximately $1.2 million of depreciation deductions over the specified 15 year period. However, by commissioning three cost segregation studies over the same time period, the building generated an additional $1.1 million of depreciation deductions.
The results are clear. The step-up rule is in place to make sure that assets in an estate are not subject to both capital gains as well as estate tax. But when a cost segregation is utilized as an estate planning tool, it is a great way to lower the tax liability on the decedent’s final return. As noted above, if a tax professional is not quick enough to identify the opportunity before the due date (even under extension) of the decedent’s final tax return, the savings are gone forever.
The new tax law does not only provide 100% bonus depreciation for qualifying reclassified property, but it also expands the qualification criteria to include qualifying used property. A real estate investor can take advantage of the tax saving opportunities by undertaking proper planning and cost segregation study. Engineers and tax experts should be consulted to ensure that maximum tax benefits under the new legislation are achieved.