WHAT IS COST SEGREGATION?
Simply put cost segregation is an alternative to standard depreciation. It changes the allocation of rental and commercial property components for federal income tax purposes. The standard depreciation for rental and commercial property is usually long-term covering 27.5 or 39 years of asset life. Segregation more closely defines the asset by identifying shorter term non-structural components within the asset. Typically, these shorter life terms are 5, 7, and 15 years.
WHY SHOULD YOU CARE?
Shifting portions of the property to non-structural status allows a reduction of income tax by generating an extra 30% to 70% in tax depreciation deductions. The result is increased cash flow. Additionally, extra depreciation converts ordinary rental income at your current tax rate to tax-deferred capital gain when you dispose of the property. This effectively increases your return on investment. The higher your tax bracket, the more savings to you. If you pay state income tax your savings is enhanced even further. If you are subject to Alternative Minimum Tax cost segregation could save money there too. Cost segregation depreciation would probably not be subjected to Alternative Minimum Tax and would not by itself trigger AMT. Property taxes are calculated as a percentage of building costs. Personal property or non-structural components are not subject to property taxes. By segregating these components you can permanently reduce the tax. Insurance costs may also be reduced by identifying components that do not require insurance.
WHAT IS A COST SEGREGATION REPORT?
It’s a report containing existing data and documents on the subject property. The report identifies qualified items, values them, and assigns the correct depreciation life according to IRS rules and court decisions. An experienced appraiser or engineer would normally prepare this report by visiting the property and collecting the necessary information. You cannot prepare your own report. The report must contain the 13 principal elements to withstand IRS scrutiny.
IS COST SEGREGATION AN INVITATION FOR AN AUDIT?
No. Some taxpayers think cost segregation is high-risk tax planning. A properly prepared well documented report more accurately reflects taxable income and is no more aggressive than using any other approved depreciation system.
IS COST SEGREGATION FOR YOU?
Get with a qualified tax person who has training in this area of tax law. Discuss whether you actually pay tax. What type of income do you have? Are you a passive owner, active owner, or real estate professional as defined by the Internal Revenue Code? A qualified tax person should be able to provide a preliminary analysis to evaluate tax consequences both from an income tax perspective and a capital gain perspective.
WHAT PROPERTIES QUALIFY FOR COST SEGREGATION?
Apartments, Rental Homes/Duplexes/Condos/Townhouses, Restaurants, Office Buildings, Hospitals, Hotels, just to name a few. Your personal residence does not qualify.
NEVER HEARD OF COST SEGREGATION?
Your tax person may not be familiar with this concept. This is somewhat of a specialized area of tax law and requires additional study above and beyond the normal requirements to be implemented properly.