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How Cost Segregation Affects Recapture

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 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) with the cost segregation study attached.

What is Recapture?

When a taxpayer sells a property at a gain, the tax code forces the taxpayer to pay back part of the allowed or allowable depreciation deductions at ordinary income tax rates. Because the taxpayer previously deducted depreciation at ordinary income tax rates, they do not get to use favorable capital gains tax rates on the gain attributable to the allowed or allowable depreciation deductions.

Cost Segregation and Recapture?

In the world of 100% bonus depreciation, if you do a cost segregation study, you push all of your accelerated depreciation into the first year. Often the deductions are so large that you can’t absorb the full deduction. That’s good news for planning opportunities and for lowering tax liabilities.

With that being said, you only trigger recapture in a few situations. You can trigger recapture with like-kind exchanges, or if you have a sale at a gain or even when selling at an overall loss can trigger recapture on a part of the sale. But, if you do a cost segregation study and sell at a gain, then you are probably looking at recapture. If you DO have recapture, you will recapture your 1245 assets and your 1250 assets at different rates. That’s because 1245 assets are recaptured at ordinary rates and 1250 assets are a lot more complicated. 1250 assets have two forms of recapture. If they use a depreciation method more accelerated than the straight-line method, they recapture the excess of the depreciation over straight line at ordinary income rates. The depreciation up to the straight-line amount is “unrecaptured” 1250 gain taxed at a maximum 25% rate. When dealing with QIP or land improvements, recapture on 1250 assets is common.

By limiting depreciation recapture or limiting it to unrecaptured gain, a taxpayer can actually make money by taking deductions at ordinary income rates and recognizing gain at capital gains rates. Using a sales price allocation cost segregation study can help with this approach. Also, you may be selling all the assets on the books but be careful not to recapture assets that are no longer on the books. Make sure your fixed asset listing is cleaned up prior to a sale.

Recapture and Opportunity Zones

When selling property for a significant gain, more and more people may be bypassing 1031 exchanges because they need more than 180 days to find replacement property—or because they’d like to roll their gains into one of many Opportunity Zones. Opportunity Zones are a great tool for turning off recapture. If you meet the 10-year hold requirement, all of the appreciation is tax exempt, and you don’t recapture your depreciation on your 1245 or 1250 assets.

The Source Advisors Approach

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.

Another thing that separates us from the competition is that we have a national presence. Our project managers are located in all major markets across the United States. We also follow the IRS cost segregation guidelines. Our studies are designed to meet the expectations of the IRS as described in its Cost Segregation Audit Techniques Guide. And finally, audit defense is included in all cost segregation studies that we perform.

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