A Study in Cost Segregation
By Erica Vernon, Partner, CPA and Nathaniel Jordan, CPA
Developers and owners who are in the business of purchasing, constructing, rehabilitating, and renovating rental real estate property have the potential to lose out on tax savings and increased cash flow as a result of improperly classifying acquisition, construction, and renovation costs. Performing a cost segregation study can help ensure that the tax benefits of proper classification are maximized.
A cost segregation study, which is commonly performed by a CPA or other qualified practitioner, drills down into the details of fixed asset allocation based on costs incurred to acquire or rehabilitate rental real estate. In doing so, the study identifies those assets that should be reclassified out of real property assets and into an asset class that is depreciated over a shorter period of time. A shorter depreciable life means more expense now. More expense now means greater reduction in taxable income. Reduction in taxable income means that more cash remains in your pocket.
Given that rental real estate is depreciated over a 27.5 year life for residential property and 39 year life for nonresidential property, and that cost segregation studies often result in assets being reclassified into asset classes with depreciable lives of 5, 7, or 15 years, the tax benefits can be substantial.
In practice, suppose Company A capitalizes new construction costs of $5,000,000 into a residential real property asset class, setting that asset up to be depreciated over 27.5 years on a straight-line basis of $181,818 per year. After a cost segregation study, it is determined that $400,000 of those costs should be reclassified to the furniture/fixtures asset class and depreciated over 5 years on a double declining balance basis of $160,000 in the first year. Depreciation expense has now gone from $181,818 in the first year to $327,273 in the first year. The $145,455 increase in annual depreciation expense stemming from the reclassification of costs means that much more will be deducted from taxable income, creating tax savings now.
Additionally, reclassifying certain costs to other asset classes means bonus depreciation can often be taken to further increase deductions up front. For qualifying property acquired and in service after 9/27/17 and before 1/1/23, the bonus depreciation percentage is 100 percent. In other words, 100 percent of the cost of the asset can be deducted in the year it is acquired or placed in service. In the above example, this means that the $400,000 could be expensed as bonus depreciation in the first year, creating a substantially higher deduction than if the asset had been depreciated as real property over 27.5 years. Qualifying property for bonus depreciation, in general, is all new or used assets with a depreciable life of 20 years or less. This includes equipment, furniture, and land improvements. However, there are some exceptions and special rules. Consult your tax advisor to discuss your specific situation to determine if your assets are eligible for bonus depreciation.
If you are looking to acquire, construct, rehabilitate, or renovate rental real estate, consider having a cost segregation study performed by your CPA or qualified professional.
Erica B. Vernon Partner, CPA
Erica is an assurance partner at our firm, where she has worked since 2000. She works primarily with non-profit organizations, real estate developers, construction contractors and clients involved in the affordable housing industry, including tax credit properties (LIHTC, Historic, Bonds), U.S. Department of Housing and Urban Development and U.S. Department of Agriculture Rural Development sites. She […]