Cost Segregation Studies (CSS) have become more common because this Internal Revenue Service (IRS)-approved process reduces income tax and increases cash flow. Intelligently executed, cost segregation will provide real estate owners with an IRS sanctioned cash windfall. Property owners that generate extra depreciation can convert income that would be taxed at 35 percent to income taxed at 15 percent.
In addition, taxes are payable when the property is sold. Investors both reduce the tax rate (from 35% to 15%) and defer payment of income taxes.
Property owners that generate extra depreciation can convert income that would be taxed at 35 percent to income taxed at 15 percent. Thus, investors’ taxes are both reduced and deferred.
Typically, the increased depreciation in early years of ownership can offset much of the income derived from the property. When depreciation advantages expire, the property can be sold, and taxes are paid at the capital gains rate of 15 percent. In such cases, this defers income taxes by five, 10 or even 15-plus years.
Thus, carefully timed, cost segregation can lower the investor’s income tax rate from 35 percent to 15 percent. Of course, there are no taxes paid if the owner elects to conduct a 1031 exchange.
Cost segregation allows the property owner to achieve accurate and timely depreciation instead of deferring much of it for 39 years (for commercial property) or 27.5 years (for apartments). Imagine waiting 39 years to depreciate carpet that wore out after five! Incredibly, this is more common than not.
Listed below are examples of 5-year, 7-year and 15-year depreciable properties:
- 5-Year: carpeting and vinyl tile.
- 7-Year: unexpensed office furnishings and cluster mailboxes
- 15-Year: landscaping, parking lots and sidewalks
Such items typically represent 20 percent to 40 percent of the total cost. By properly depreciating each item, investors can increase depreciation by 50 percent to 75 percent during the early years of ownership.
If the owner has not already identified a property’s short-life components, the investor can “catch-up” underreported depreciation in the first year after a CSS without amending prior tax returns. The investor’s accountant simply prepares a Form 3115 (change in accounting method), which corrects the depreciation.