Cost Segregation and Estate Planning

Brian Coddington | Source Advisors

26 Jul, 2020. 7 min read
Cost Segregation and Estate Planning

What is cost segregation?

Cost segregation is a highly beneficial and widely accepted tax compliance strategy utilized by commercial real estate owners and tenants to accelerate depreciation deductions, defer tax, and improve cash flow. Once used only by big-4 type accounting firms and the nation’s largest real estate owners, this practice has now become routine for commercial property owners of almost every size.

Cost segregation is considered one of the most effective tax strategies for real estate owners and investors and is one of the top niche services for accounting firms. You may be leaving serious tax benefits on the table by not using it. It’s not just for newly constructed or newly acquired assets and it can dramatically increase your cash flow.

When should a cost segregation study be performed?

There are several situations where a cost segregation study should be performed. A cost segregation study should be performed immediately after construction or acquisition or following major capital improvements (including leasehold improvements). The study can also be performed after a change in ownership, including inherited property and a change in partnership interest. And, finally, a cost segregation study can be useful for buildings already in service. In this situation, a Look-back study would be performed.

The IRS permits taxpayers to use a cost segregation study to adjust depreciation on properties placed in service as far back as January 1, 1987. Many property owners and tax advisors share a common misconception that once the three-year statute to amend has expired, the taxpayer can no longer make a change. Fortunately, this is not the case. Upon completion of the study, the taxpayer is allowed to make an adjustment under IRC §481(a) to catch up on depreciation. The catch-up, which is taken in a single year, is equal to the difference between what was depreciated and what could have been depreciated if a cost segregation study was performed on day one.

Expectedly, these benefits can be quite substantial. As an added bonus, the change can be made without filing an amended return. The taxpayer simply files Form 3115 (Change in Accounting Method).

Who can benefit the most from cost segregation?

You can seriously benefit from a cost segregation study if your building or improvements were placed-in-service since 1987, but most studies are limited to the last 5-7 years. You can also benefit if your building or improvements are currently depreciating over 27.5 or 39 years. If you have over $1,000,000 in capitalized costs, it’s a good idea to begin thinking about cost segregation.

Ideal building types include apartment complexes, auto dealerships, banks, casinos, distribution centers, grocery stores, health care facilities, hotels, manufacturing facilities, nursing homes, office buildings, restaurants, shopping centers, sports facilities, warehouses, and other specialized property types. Typically, the more complex buildings will generate the greatest benefit from a cost segregation study. It’s important to note that the property owner must be a tax-paying entity.

It’s important to note that the property owner must be a tax-paying entity.

Using cost segregation for estate planning

Contrary to popular misconception, the concepts of estate planning and cost segregation are not mutually exclusive. In fact, a cost segregation study (CSS) can enhance the estate planning process by lowering the tax burden of the property owner. The two key benefits of using cost segregation in the estate plan are the acceleration of depreciation and the ability to avoid potential recapture. Both have a significant and positive impact on cash flow.

Typically, after a death in the family, the heirs’ tax-planning efforts focus on how the assets will be distributed and what impact it might have for them. Many people can overlook valuable opportunities that exist to reduce the deceased’s final income tax liability. A cost segregation study can be used to claim missed deductions on the deceased’s final income tax return, while also avoiding depreciation recapture, which gets wiped out in the basis step-up on death. This increases the estate available to the heirs.

Will cost segregation put me at risk of an IRS audit?

You are at no greater risk with new assets (acquisition or new construction) than you are in filing any income tax return. Additionally, the general feeling throughout the cost segregation industry is that the IRS has been getting a bit more aggressive about the review of cost segregations studies; specifically with respect to the methodologies being used and the qualifications of the preparer. Per the IRS Audit Techniques Guide, studies being performed by unqualified individuals and those using an abbreviated methodology will receive higher scrutiny than the ones performed by qualified professional who utilized the detailed engineering-based approach. Therefore, it is more important than ever to have your studies performed by an expert in the field.

The Source Advisors approach

At Source Advisors, relationships matter. Trust, integrity, and hard work are core values that have driven our success and created partnerships with many of the nation’s most prominent accounting firms, associations, and Fortune 1000 companies.

Our approach to cost segregation follows these values. At Source Advisors, we don’t train our team on your dime. We only hire heavily experienced cost segregation specialists. We believe experience is critical to maximizing the benefits of cost segregation, and the majority of our team has spent between 10 and 20+ years managing cost segregation projects.

We have a specialized in-house dedicated cost segregation team. Our team is composed of architects, professional engineers, CPAs, MBAs and LEED cost segregation specialists dedicated solely to cost segregation. Our management team is involved in every project we’re engaged to perform and often conduct the site visits themselves. And, with rare exceptions, we always conduct a site visit. The IRS expects it, and we believe it is the best way to accurately assess a property.

We believe experience is critical to maximizing the benefits of cost segregation, and the majority of our team has spent between 10 and 20+ years managing cost segregation projects.

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