Top 3 Considerations Explained
As a nationwide provider of cost segregation studies, one of the questions we hear most from building owners and tax advisors is “when does it make sense to do a cost segregation study?” The past few years have seen a massive increase in the popularity of this long-established tax benefit. However, while influencers and specialty consultants are apt to push cost segregation as a must-have tax strategy, it may not make sense for everyone. After reading this article, you should be able to identify when and where it makes sense to perform a cost segregation tax analysis.
What is Cost Segregation?
Cost Segregation is a tax strategy that allows building owners to accelerate the depreciation deductions that would be taken over the life of a building. Higher depreciation deductions equal lower taxable income equals a lower tax bill. So, when does it make sense to use this strategy?
- Long Term Ownership
Cost Segregation does not make sense for owners who plan to sell the building in the short term (three years or less). If you do a cost segregation study and sell the building within the next few years, the capital gains rate will increase due to a rule known as depreciation recapture. Therefore, while you will have benefited from lower taxes after the cost segregation, it may be diminished by the increase in taxes owed after selling the building. The bottom line, if you are thinking of using cost segregation, you should plan on holding the building for at least three years or more.
- Depreciable Basis
Perhaps the most important component of the “when should I do a cost segregation” question is a taxpayer’s basis in the property. Basis is the total capital cost of a property that a taxpayer will report on their tax return. A cost segregation study starts to make sense when the depreciable basis (less land) is $400,000 or more. Anything less than $400,000 often does not yield enough tax savings to justify the cost of performing a study. Therefore, a higher depreciable basis means a better rate of return.
It is possible for taxpayers to find a cost segregation service for buildings with lower basis. However, for the fee/benefit ratio to make sense, these studies often are not engineered cost segs and will omit a site assessments. Taxpayers need to be careful here as the IRS has made it clear that they will reject cost segregation studies without a site visit.
With that being said, there may be other instances when a small-basis building can benefit from cost segregation. If a taxpayer has multiple small-basis buildings within a portfolio or has one small building that is a part of larger portfolio that is being serviced, then cost segregation for the small building might make sense.
- Passive Activity Loss Limitations
If a taxpayer is implementing a cost segregation study on real estate that is considered a passive activity, further considerations are required. All of the additional deductions and losses generated from cost segregation will not make sense if the real estate activity is considered passive. Passive activity limitations and net income need to be considered before paying for a cost segregation study.
In general, cost segregation is ideal for the following candidates:
- Real estate professionals or REPS (more than half of all hours worked are in real estate, 750 hours minimum).
- Owners who can use “material participation rules.”
- Owners of profitable real estate operations (regardless of passive or active)
- Owners with modified adjusted gross income (MAGI) of $100,000 or less can use deduction against non-real estate income
- Owners who run a business in one LLC and own the building in a separate LLC
- Owners of short-term rental properties (hotels, Airbnb, vacation rentals) – See our blog Tax Breaks For Short Term Rentals
Conclusion
Cost segregation is a very beneficial tax strategy. However, building owners and their advisors should make sure that factors such as those discussed here are considered before paying for a cost segregation study. If you have question on whether or not cost segregation makes sense for your building, please contact ATS today.
