Commercial property owners typically use tax preparation specialists such as tax lawyers, CPAs and accountants. They reasonably assume these experts will maximize their tax deductions to minimize federal income taxes. However, the complexity of the IRS tax code for federal income taxes makes it virtually impossible for any person to have a depth of knowledge for all industries.
Cost segregation identifies applicable components and establishes the value and correct time line for depreciation. Under typical circumstances, depreciation is spread out over as long as 39 years. However, cost segregation applies depreciation to parts of the property in 5-, 7- and 15-year increments. This acceleration in depreciation time reduces the income subject to federal income taxes. This method does not dictate alternative minimum tax issues.
Many CPAs Recommend Cost Segregation
Most property owners instinctively believe their CPAs are performing cost segregation for them, but research has suggested that this tool is used only 5% – 10% of the time. CPAs, tax lawyers and other tax preparers may not routinely perform the study because it involves real estate appraisal methodology and specialized knowledge outside the scope of a typical tax practice. Even though cost segregation may be unfamiliar territory to some accounting professionals, it is highly praised by many accountants.
Cost segregation is a powerful and necessary part of accurately calculating depreciation for real property, comments CPA Bill Bandy of Blakely and Bandy, a Houston-based accounting firm. A properly prepared study is invaluable to me as a CPA because it provides reliable support for preparing the depreciation schedule and reducing my clients taxes. Recent changes in tax regulations make cost segregation more attractive and allow it to be implemented years after the completion of a real estate purchase. Commercial real estate owners can generate meaningful federal income tax reduction by using catch-up depreciation for buildings acquired or built after 1986. This amplifies the level of tax deductions, affecting a large tax cut.
How Does It Work?
Historically, most depreciation schedules are split between land and long-life property. Long-life property depreciates over 27.5 years for apartments and 39 years for most commercial properties. A cost segregation study can typically allocate 20% to 40% of the improvement basis to short-life categories.
High-income owners typically pay a 35% federal income tax rate on ordinary income and a 15% rate on capital gains. The mechanics of reporting the gain on a sale usually allocates most of the income to capital gains, which is taxed at 15%. By increasing tax deductions (depreciation), the commercial real estate owner pays the capital gains tax rate (15% maximum) for most income and also defers payment of federal income taxes.
A cost segregation study reduces the amount of long-life property, which is recaptured at 25% by allocating more of the basis to the 5-,7- and 15-year property. If cost segregation is utilized from inception until a gain on the property is recognized, it can reduce the federal tax rate from 35% to 15% for most investors. The exceptions are C corporations, which pay the same tax rate for either ordinary income or capital gains.
How Much Can It Save?
The annual tax savings through cost segregation can be significant. The following table summarizes actual first-year tax savings generated in cost segregation reports prepared by OConnor & Associates, a national real estate consulting firm.
Range on Year 1 Tax Savings
(100,000-500,000 sq. ft. property size)
$35,500 – $160,000
$19,240 – $96,200
$36,500 – $182,600
$10,800 – $54,000