Myths and Realities about Cost Segregation
Myth: My accountant already makes sure I get all allowable depreciation.
Reality: As we all know, IRS rules and regulations are extremely complex. Cost segregation involves not only specialized tax law knowledge, but construction engineering expertise such as the ability to read blueprints and building specifications. Even if your accountant understands the basics of cost segregation, without contractor/engineer expertise and a deep understanding of the relevant tax law changes, IRS Private Letter Rulings and court cases, valuable tax benefits will certainly be missed. IRS cost segregation audit guidelines clearly state that “a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background.”If your accountant is currently using the straight-line method of depreciation, it is highly likely that anywhere from 25% to 50% of building components can be reclassified to shorter depreciable lives, resulting in significant tax savings. On buildings where the owner has made substantial renovations, 90% of the costs could potentially qualify for accelerated depreciation, even where the building has been fully depreciated.
Myth: A study costs more money and hassle than it is worth.
Reality: In the early days of cost segregation this might have been true, especially for owners of smaller commercial buildings. However, experience and methodology have brought costs within reach of the vast majority of commercial property owners . Further, the time and effort involved on the part of building owners or managers is minimal. And the savings can be substantial for any owner who pays federal income taxes. Savings generally range from 35% to 46% of the additional depreciation generated from the study.Myth: It’s too late to change our depreciation method.
Reality: Many owners and their accountants think that once they have established an accounting method they are locked into that way of depreciating their building. This myth keeps many owners from realizing one of the key advantages of cost segregation. For the perspective of the IRS, an owner who applies cost segregation is changing from an incorrect method, straight line, to a correct method, component depreciation. Not only is this change in method permitted, approval is automatic once a qualified cost segregation study has been performed and the building owner has completed and submitted an IRS form 3115. What’s more, IRS rules allow you to realize all of the depreciation adjustment for prior years in the year the study is completed, which can mean an immediate and significant increase in cash flow.Myth: Doing a cost segregation study will trigger an audit.
Reality:More than 75 IRS rulings, procedures and court cases have upheld the validity of cost segregation studies. Also, the IRS has published detailed audit guidelines and field directives for performing and documenting studies. Cost Segregation Services, Inc. has completed thousands of studies without a single successful challenge from the IRS. In the unlikely event of an IRS challenge, Cost Segregation Services, Inc. will provide one of our engineers, at our expense, to defend every aspect of any study we complete.Myth: Doing a cost segregation study means I’ll owe more tax when I sell.
Reality: Not necessarily. In many cases a 1031 exchange can be a viable option for owners planning to sell in the short term who still want to take advantage of cost segregation. Even if you do recapture the depreciation when you sell, you are gaining the use of that money now. In essence, performing a cost segregation study entitles you to a long term interest-free loan from the federal government. In most cases, the net present value of the tax savings provides a substantial return over the relatively modest cost of a study.Also, in most cases the personal property components will depreciate in actual value, so their value at the time of sale will be close to their depreciation cost basis. Thus more of the sale gain will be allocated to real estate rather than personal property and taxed at the lower capital gains rate.
Myth: A cost segregation study makes sense only for large commercial properties.
Reality: Using a cost-effective approach, and depending on the type of property, a cost segregation study can be a worthwhile investment for properties with values as low as $300,000.Myth: Doing a study means I will have to amend my past year returns.
Reality: Section 2.01 of the Appendix of Revenue Procedure 2002-9 allows an automatic change of accounting method without amending past returns. Your accountant will need to complete a form 3115 showing the calculation of the depreciation adjustment following the study.It doesn’t matter who performs a cost segregation study.
Reality: Actually it matters a great deal. Because there is no “bright line” test for determining what items can be included in a cost segregation study, study levels can vary widely with corresponding variations in both cost and tax savings. A cost segregation study done at 10,000 feet by a CPA with no engineering or construction cost-estimating background might identify a few items, such as carpet or a parking lot, that qualify for accelerated depreciation. It is extremely unlikely, however, that this approach will identify more than a small fraction of what an owner is entitled to. More importantly, this methodology will not withstand IRS scrutiny.As an example, an engineered cost segregation study on a $1,000,000 building should result in $250,000 to $500,000 of the components being accelerated, providing actual tax savings that could range anywhere from $87,500 to $230,000. Identifying all of the building items that can legitimately be accelerated requires specialized construction and engineering expertise combined with in-depth knowledge of the tax laws, IRS rules and court cases governing cost segregation studies. This is a key reason to choose a highly experienced team such as the one available with Cost Segregation Services, Inc.
