Cost segregation is an accelerated depreciation technique that sophisticated real estate investors use to reduce their tax burden and increase after-tax cash flow. Cost segregation is accomplished with a cost segregation study.

A cost segregation study is a comprehensive analysis whereby personal property assets and land improvement assets are identified and segregated from real property assets for tax reporting purposes. According to IRS Publication 946, “Appliances, carpets, furniture, etc., used in a residential rental real estate activity” can be classified as “5-year property” and depreciated using the “200% declining balance” method. In addition, “certain improvements made directly to land or added to it (such as shrubbery, fences, roads, and bridges)” can be classified as “15-year property” and be depreciated using the “150% declining balance” method. These 5 and 15 year asset class buckets result in accelerated depreciation, which reduces the investor’s tax burden and increases after-tax cash flow.

A cost segregation study provides:

• Increased cash flow through accelerated depreciation write-offs.
• An opportunity to claim “catch-up” depreciation on previously misclassified assets without having to amend a prior tax return.
• The potential for little to no recapture of the 5 and 15 year asset classes upon disposition (please consult your CPA).
• Information that is valuable in managing capitalized assets.

Yes. Please refer to IRS Publication 946 and the IRS Cost Segregation Study Audit Techniques Guide for more information.

Cost segregation studies for sophisticated real estate owners have been around since 1997. Since then, the “Big 4” accounting firms and a select group of other national and regional accounting firms have used cost segregation for their wealthier real estate clients. It has only been within the last few years that this application has been made available to smaller properties.

According to the IRS Cost Segregation Audit Techniques Guide, there are 6 different methodologies:

• Detailed engineering approach from actual cost records.
• Detailed engineering cost estimate approach.
• Survey or letter approach.
• Residual estimation approach.
• Sampling or modeling approach.
• “Rule of Thumb” approach.

Our methodology most closely resembles the detailed engineering cost estimate approach. Our personal belief is that the first two approaches are the best and most easily supported in the case of an IRS audit, and that investors should be wary of Cost Segregation companies that use one of the last four approaches mentioned above.

A cost segregation study will not increase your chance of an audit, provided it is done properly. The IRS provides guidance on this subject. In chapter 4 of the IRS Cost Segregation Audit Technique Guide, the IRS establishes the 13 principal elements of an acceptable Study. At Redtec Solutions, we believe our report meets all of these elements. For a property that has been depreciated on prior tax returns, the cost segregation study will require the filing of IRS Form 3115 (“Application for Change of Accounting Method”). The IRS has pre-approved the use of IRS Form 3115 as long as it is filled out correctly.

Any investor that owns income producing real estate should consider a cost segregation study. Depending on the investor’s federal marginal tax bracket, tax situation, basis in the property, and amount of personal property/land improvements, the benefit of the cost segregation study (in terms of tax savings) typically more than offsets the cost of the study in the year the study is completed. Please refer to the Powerpoint presentation for a real life example.

In general, it depends on how expensive the study is and how long you will hold the property (to realize the benefit of the study). When using Redtec Solutions, we believe that cost segregation studies are most cost effective on residential properties that are purchased for $100,000 or more.

Your property is eligible for a cost segregation study if:

• It was purchased after 1986, or
• It was newly constructed after 1986

Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation study is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties to increase cash flow in the current year. For more details, please consult your CPA.

There are two cases to address here:

• If you have specifically identified certain items with a value on your prior tax returns (i.e. refrigerator $400, stove $350, etc.), then the reported values cannot change for these items. However, you will likely still benefit from a report since you may identify additional items that were not segregated on a prior year’s tax return. These would be added to the current year return and the building value reduced accordingly.
• If your previous tax return used a “lump” sum amount (e.g. personal property $2700), then you can use the cost segregation study as substantiation for the original amount and add specific property/amounts over the original amount to get the remaining depreciation. These would be added to the current year return and the building value reduced accordingly.

Keep in mind: if the rental property has been depreciated on a prior return, you are required to file IRS Form 3115 (“Application for Change of Accounting Method”). This notifies the IRS that you have made changes to the depreciation method used previously and allows you to take additional depreciation expense in the current year, since you can take accelerated depreciation for prior years all at once. Please consult your CPA.