Real estate investors find themselves asking one important question: can I do my own cost segregation study? The answer is of course yes, but is it really worth the headaches and risks?
A do-it-yourself method of cost segregation can be tempting. The belief is that it will save the costs of the study while enjoying all the tax benefits that cost segregation provides. However, following a do-it-yourself approach to cost segregation can be time-consuming and fraught with risk.
But before we dive into the details, let’s make one thing clear. At Simple SEG, we understand that cost segregation can be expensive. That’s why we perform $299 cost segregation studies for single family homes with a value less than $500,000. So with such a low price point does it really make sense to do your own study?
Can I do my own cost segregation?
To create such a study, the investor must examine the IRS depreciation policies on land, land improvements, and personal property and understand the difference between Section 1245 and Section 1250 property. They must be able to classify their property according to the proper property classes (land, land improvements, building, equipment, furniture and fixtures).
The IRS defines thirteen principle elements of a quality cost segregation study:
- Preparation by someone experience and expertise
- Detailed description of the cost segregation methodology
- Use of appropriate documentation
- Interviews conducted with appropriate parties
- Use of a common nomenclature
- Use of a standard numbering system
- Explanation of the legal analysis
- Determination of unit costs and engineering “take-offs”
- Organization of assets into lists or groups
- Reconciliation of final allocated costs to total the actual costs
- Explanation of the treatment of indirect costs
- Identification and listing of § 1245 property
- Consideration of a variety of related aspects (i.e. sampling techniques, change in accounting, etc)
An average investor who decides to perform their own cost segregation study will not be cognizant of the ins and outs of the cost segregation methodology and documentation procedures. They are likely to make mistakes resulting in over- or under-depreciation. Take a look at our dummies post.
For example, remodeling an item in an existing home, such as windows that are attached to a wall, may seem to be easily quantifiable, and a do-it-yourself study may assume that the windows can be depreciated over the requisite life span.
However, such a remodel also changes the existing value of the building itself and continuing to depreciate the building using the initial value, plus the value of the remodeled windows can result in the depreciation of disposed assets (a red flag for the IRS).
If an audit arises, it is possible that the IRS may throw out a do-it-yourself cost segregation study if it does not meet their documentation requirements and the investor may find they owe fines, penalties or back taxes.
Can I Do My Own Cost Segregation Study?
While it can be tempting to save money, the risks clearly outweigh the benefits. A qualified individual who is familiar with the study process will be able to classify property correctly and ensure that it complies with IRS regulations. A full set of documentation will be provided that can be used to quantify depreciation on the investor’s return and explain the legal nomenclature, cost basis and methodology used to develop the cost segregation study.
When choosing a cost segregation study firm, the real estate investor should seek professionals who have a constructional engineering, architectural or real estate background and are familiar with the tax code. These firms will understand the cost segregation process and what must be included within a proper analysis.
Cost Segregation Process
The process of cost segregation can be intimidating to a new rental property real estate investor. Identifying aspects of the property that can be allocated to specific asset categories is time-consuming and tedious. A good template can come in handy.
However, an up-front effort of identifying such property can pay off exponentially come tax time and in future years, since depreciation of items classified into personal property and land improvements will result in a shorter timeline for depreciation and a lower tax burden. Common property that can be segregated include:
Personal property (5-7 years)
- Furniture
- Carpeting
- Accent lighting
- Cabinetry
- Fencing
- Molding
- Wall coverings
- Pool equipment
- Window treatments
- Exterior shutters
- Security systems
- Exterior lighting
- Ceiling fans
- Vinyl flooring
- Specialty plumbing
Land improvements (10-15 years)
- Sidewalks and curbing
- Landscaping
- In-ground and above-ground pools
- Equipment enclosures
As a straightforward example, consider a single-family home with a purchase price of $300,000. The building basis is 85%, and the land basis is 15%. A cost segregation study found the following:
Personal property (5-7 years):
- Carpeting – $10,000
- Accent lighting – $4,000
- Cabinetry – $10,000
- Fencing – $2,000
- Molding – $2,000
- Exterior shutters – $5,000
- Ceiling fans – $2,000
- Total: $35,000
Land improvements (10-15 years)
- Sidewalks and curbing – $20,000
- Landscaping – $5,000
- Total: $25,000
The segregation study has identified $60,000 of property that can be depreciated within a shorter timeline of the original $255,000 building basis of the property. As a comparison, let’s show the difference in deprecation between the original rental property and its value with the proper cost segregation technique, assuming that all personal property is depreciated over five years and the land improvements are depreciated over fifteen years.
Depreciation under standard 27.5-year recovery period prescribed from the IRS:
$255,000 building basis / 27.5 years = $9,273 during the first year (and thereafter)
Depreciation using the cost segregation study:
- $195,000 building basis / 27.5 years = $7,091 per year
- $35,000 personal property / 5 years = $7,000 per year
- $25,000 land improvements / 15 years = $1,667 per year
- Total depreciation = $15,758 during the first year
Thus, the investor who chooses to undergo the cost segregation study will realize an additional $6,485 deduction for depreciation in the first year of the investment. Such a savings clearly shows the benefits of undergoing the study and enables the investor to better align the property’s useful life of its amenities to prepare for future probable repairs and replacements of personal property and land improvements.
So if you find yourself asking the question – can I do my own cost segregation study – you may know the answer. Of course you could. But with the risks involved and the affordable options on the market it just may not make that much sense.