Cost Segregation Study

By Jason Watson, CPA
Posted Saturday, August 3, 2024

When you buy real estate for business or rental use, you can depreciate the entire purchase price, minus the land value, over 27.5 or 39.0 years depending on the designated use (residential versus nonresidential / commercial / short-term). This can feel like forever. Not just forever, but forever and ever.

For example, if you purchase a $400,000 single-family rental property and $100,000 is attributed to the land, you can depreciate about $10,909 annually. This is 3.64% of the $300,000 value attributed to the building.

At a mid-range marginal tax rate of 24%, this puts $2,618 into your pocket. Not shabby. But what if you could depreciate in big chunks? What about $60,000 in one year (which is a good starting point using our example above)? Now you get to put $14,400 extra in your pocket during the first year. Accelerated cash flow is always nice. Time-value of money. All that stuff. Yay!

Brief History of Cost Segregation

How did we get here? Several items in a building do not last 27.5 or 39.0 years. Recall that one of the fundamentals to depreciation is to expense the asset over its useful life. However, carpeting, lighting, heating or cooling systems, cabinets, landscaping, and land improvements might not last as long as the building itself.

Thankfully the tax court recognized this issue in Hospital Corporation of America v. Commissioner, 109 Tax Court 21 (1997). In response, the IRS issued an Action on Decision (AOD) 1999-008 on August 30, 1999. In part, it reads-

On their tax returns for 1985 through 1988, the taxpayers classified as tangible personal property certain items in hospital facilities constructed in those years and took depreciation deductions for them using a 5-year recovery period … The Commissioner determined that the items were structural components of the hospital facilities and not tangible personal property and, therefore, should be depreciated over the same recovery period as the facilities to which they related.

In the Tax Court, the taxpayers argued that the items constituted section 1245 property, and, therefore, were appropriately depreciated using a 5-year recovery period … Further, the Commissioner argued that section 168(f)(1) effectively operates to change the definition of tangible personal property after 1981, thereby precluding such property item from being classified as section 1245 property, if it is attached to a building and has utility beyond its relation to a particular piece of property. It was the Commissioner’s position that the items were structural components and thus section 1250 property and, therefore, should be depreciated over the same recovery period as the building to which they relate.

The Tax Court found that most of the assets at issue were section 1245 property. The Court rejected the Commissioner’s primary argument stating that the test developed with respect to ITC and Treas. Reg. § 1.48-1(e) were inappropriate after the enactment of ACRS in 1981. The court concluded, after reviewing the statutory and regulatory language and case law, that, while Congress did prohibit the use of component depreciation, there was no intent to redefine section 1250 property under ACRS to include property that had been section 1245 property for purposes of the investment tax credit.

As a result, the IRS relented, and stated in their AOD,

We acquiesce in this decision to the extent that the Tax Court held that the term “tangible personal property,” as defined under a pre-1981 ITC analysis, has continued viability under ACRS and MACRS. The issue as to whether the various disputed items are structural components or tangible personal property is a factual question. We do not agree with the court’s determination with respect to the various disputed properties. We cannot state, however, that the court was clearly erroneous.

We’ll review what 1245, 1250, investment tax credit, and the terms above mean.

Cost Segregation Study Mechanics

How does all this black magic work? With a cost segregation report, or some say a cost segregation study, all the sticks, bricks and stuff inside are figuratively torn down and put into different piles. Some piles are eligible for instant depreciation (unlike the hominy grits in My Cousin Vinny), one pile might be a 5-year pile, another be a 15-year pile, and the remaining pile might revert to the 27.5- or 39.0-year typical residential or nonresidential commercial use depreciation.

Sidebar: A short-term rental property that has an average guest stay of 7 days or fewer where you materially participate in the activity is considered a commercial activity, and as such will be 39.0 years. We discuss the short-term rental (STR) loophole in great detail on page xx.

Technically, and with full-on geek-speak, cost segregation separates property elements that are “dedicated, decorative or removable” from those that are “necessary and ordinary for operation and maintenance of the building.” These piles are called asset classes, and they are maintained separately within your property’s depreciation schedule.

From there, and with the help of bonus depreciation and in some cases Section 179 expensing, you compress the multiple years into one. Yay! Whether this accelerated rental property depreciation or expensing yields a tax deduction / tax benefit and therefore increased cash flow (an improved IRR) is contingent on three general things-

• Short-term rental (7 days average guest stay + material participation), or

• Real Estate Professional designation, or

• Net rental income (profit) from the rental property, other rental properties, or other real estate investments that can be reduced by the loss.

Or some combination of the above. We’ll dig in deep on these goodies.

Section 1245 and Section 1250 Property

Please don’t groan as we go into the weeds with more nerdy accounting terms. This one is important, and we’ll try to keep it relevant. A building that is or has been depreciable is considered Section 1250 property. When a cost segregation study is performed, certain asset classes are deemed personal property and when depreciable, they become Section 1245 property.

Why do you care? Depreciation recapture, which we have not discussed yet, is limited to 25% on Section 1250 property, but Section 1245 property is recaptured at your ordinary income tax rate. As such, this becomes a big tax planning consideration. Also, Section 1245 property does not always escape depreciation recapture in a Section 1031 Like-Kind Exchange either. We expand on this and the wonderful 15% exception in a later section.

Quick recap-

• 5- or 7-year property is Section 1245 property.

• 15-year property can be either Section 1245 or Section 1250 property. Dealer’s choice! However, if you accelerate depreciation on 15-year property, such as land improvements, then it becomes Section 1245 property.

• 27.5- or 39.0-year property, such as the building and its structural components, is Section 1250 property.

How does the IRS distinguish between Section 1245 and Section 1250 property? According to IRS Publication 5653 Cost Segregation Audit Technique Guide (ATG)–

From a regulatory standpoint, the primary test for determining whether an asset is § 1245 property eligible for ITC [investment tax credit] is to ascertain that it is not a building or other inherently permanent structure, including items which are structural components of such buildings or structures. In other words, if an asset is not a building or a structural component of a building, then it can be deemed to be § 1245 property. The determination of structural component hinges on what constitutes an inherently permanent structure, how permanently the asset is attached to such a structure and whether it relates to the operation or maintenance of the structure. See Treas. Reg. §§ 1.48-1(c)-(e).

ITC references investment tax credit. How does that matter? IRC Section 1245(a)(3) and Treasury Regulations Section 1.1245-3(b)(1) read that the distinction between tangible personal property (Section 1245) and structural components (Section 1250) should be based on the criteria once used to determine whether property qualified for the now repealed investment tax credit (ITC) under IRC Section 38.

Huh? The IRS is using old tax code to define current tax code. You still awake? In 1975, the IRS refined its definition and stated in Revenue Ruling 75-178,

Rather, the problem of classification of property as ‘personal’ or ‘inherently permanent’ should be made on the basis of the manner of attachment to the land or the structure and how permanently the property is designed to remain in place.

As such, the inherently permanent test, is illustrated in the landmark Whiteco Industries, Inc. v. Commissioner, 65 Tax Court 664 (1975) court case. No, we don’t bore you with all the factors, but it is an interesting read if you cannot get enough.

Cost Segregation Report Fees

The fee for a cost segregation study varies between $750 to a bajillion dollars. There are two types of cost seg reports- one is routinely called “do it yourself” and the other is a fully engineered report. The fully-engineered report is very similar to a property appraisal- there is a site visit, a bunch of measurements and pictures are taken, and a qualified person dissects the property to create the 5-, 7- and 15-year piles. Costs range from $2,500 to $6,000 for most rental properties under $2 million(ish).

Do It Yourself Cost Segregation Study

There is a depreciable property value of about $1,500,000 where things change. Below that value, the statistical reliability and therefore predictability is very good, and most cost segregation reports can rely on basic property vitals such as address, age, price, square footage, etc. plus a quickie survey of the stuff inside. What stuff? According to CostsegEZ.com, here is a quick list-

• Removable floor coverings (i.e., carpet, vinyl, LVP, floating wood)

• Kitchen cabinets and countertops

• Kitchen appliances (including mechanical, electrical, plumbing connections)

• Laundry appliances (including mechanical, electrical, plumbing connections)

• Window treatments

• Ceiling fans

• Electrical wiring and outlets for telephones (really?!), televisions, internet

• Closet shelving

• Decorative trim and wall coverings

• Decorative light fixtures (including electrical connections)

• Hot tubs and pool equipment

• Security systems

• Furniture and decor

• Window air conditioning units

WCG CPAs & Advisors has a similar list that we use for renovations where we do a “poor man’s” version of cost segregation when a rental property owner details out a renovation or rental rehab. We discuss this later. Riveting!

How does a do it yourself cost segregation report work again? Said another way, the cost segregation report is relying on a slew of prior reports to homogenize the data and draw correlations to the basic property vitals and a survey of certain components. Plus, this technique has been successfully defended in multiple courts. Is there a risk? Are there standards?

According to IRS Publication 5653 Cost Segregation Audit Techniques Guide (ATG)–

Neither the Internal Revenue Service (Service) nor any group or association of practitioners has established any requirements or standards for the preparation of cost segregation studies. The courts have addressed component depreciation but have not specifically addressed the methodologies of cost segregation studies.

The Service has addressed this issue but only briefly, i.e., Revenue Ruling 73-410, 1973-2 C.B. 53, Private Letter Ruling (PLR) 7941002 (June 25, 1979), Chief Counsel Advice Memorandum 199921045 (April 1, 1999). These documents all emphasize that the determination of § 1245 property is factually intensive and must be supported by corroborating evidence. In addition, an underlying assumption is that the study is performed by “qualified individuals” and “professional firms” that are competent in design, construction, auditing, and estimating procedures relating to building construction (See PLR 7941002).

Despite the lack of specific requirements for preparing cost segregation studies, taxpayers still must substantiate their depreciation deductions and classifications of property. Substantiation using actual costs is more accurate that using estimates. However, in situations where estimation is the only option, the methodology and the source of any cost data should be clearly documented. In addition, estimated costs should be reconciled back to actual costs or purchase price.

The big takeaway from the blurb is the phrase “factually intensive.” It appears 7 times in the ATG. When shopping for a DIY cost seg provider, ensure you are comfortable with their reporting and see if their results feel “factually intensive.” However, do not be discouraged from using a do-it-yourself cost segregation provider- many are extensions of fully-engineered cost seg experts, and will prepare a full report should you be audited.

Opted Out of Bonus Depreciation

Bonus depreciation election is assumed. Rental property owners who fail to elect out of bonus depreciation and do not claim bonus depreciation are using an improper accounting method. Sounds naughty, right? You would need to file Form 3115 Application for Change in Accounting Method to cure.

There are some tax planning opportunities since opting out of bonus depreciation can be asset class specific. For example, you could opt out of 5-year property but not 7-year or 15-year property. This allows you to thread the needle on balancing today’s tax deduction with tomorrow’s future tax deductions relative to your taxable income.

Cost Segregation Pitfalls

There are two big pitfalls and a fewof gotchas.

Pitfall #1. If you are considering a cost segregation study on a rental property, and that activity is considered a passive activity, your tax deduction is limited to $25,000 (passive loss limit). If you earn over $150,000 as a household, your tax deduction might be limited to $0. Yes, you are reading that zero correctly. We discuss passive activity loss limitations later on page xx.

There are two ways to get around this. First, if you qualify as a real estate professional, then your passive activity loss limits go away. To be a real estate professional as defined by the IRS and not what you hear at the bar, an individual must spend more than half of the personal services performed in all businesses and activities during the year in real estate activities. As a reminder, this includes the following-

real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Read this again! If you have another full-time job in which you work 40 hours a week, you will need to work more than 40 hours per week in your real estate business and related activities. Having a W-2 is a red flag, as they say, straight out of the Passive Activities Loss Audit Techniques Guide (ATG) from the IRS.

Next, your hours worked in real estate activities must be more than 750 hours. Any work performed as an investor cannot be counted. There are a bunch of other devils in the details. Yes, most real estate agents qualify, not because they are real estate agents but rather time spent on real estate activities.

Finally, you must materially participate as defined by the IRS in each rental activity. We dive deep into real estate professional or REP status or just “REPS” as the cool kids say in a later section.

The other way to get around the passive loss limits is to have the activity not be considered passive. Makes sense right? Let’s just pencil-whip this activity and add the word “non-“ in front of it all. Done!

To be a non-passive activity, the average stay in the rental must be 7 days or less. Your typical VRBO Airbnb situation. However, you must also materially participate (there’s that darn word again) in the activity. Alternatively, for average stays of 30 days or less, you provide hotel-like services like changing linens during the stay or providing tours (think hunting lodge).

These two situations are considered non-passive activities and losses are not limited. As a small sidebar, or perhaps a minibar, the first example is reported on Schedule E, and the second is on Schedule C possibly subject to self-employment taxes.

Pitfall #2. If you can’t escape the passive activity loss limits, then you must have net rental income from the rental property or from other properties or real estate investments to absorb the accelerated depreciation expense and grab that accelerated cash flow. Self-rentals, where you own the building and lease it back to your business, do not usually absorb passive losses from other rentals. We talk about self-rentals later.

Gotcha #1. Recall that depreciation is a tax deferral. When you sell the property, you have depreciation recapture which simply means you must pay back the deferred taxes. There is some tax arbitrage here, however, since recapture is limited to a 25% tax rate on Section 1250 property (remember our mini chat about this) where you might have deducted depreciation at a 37% marginal tax rate. You can also escape this gotcha with a Section 1031 Like-Kind Exchange.

Sidebar: Recall that Section 1245 property, which might be “created” with a cost segregation report, is recaptured at ordinary income tax rates. We stated that earlier. However, the intersection of Section 1031 and Section 1245 can be problematic since you cannot like-kind exchange Section 1245 property. As such, you can perform a pretty Section 1031 Like-Kind Exchange, and still have a tax bill because of the sale of Section 1245 property in connection with the overall rental property sale.

Gotcha #2. The cost of the report or cost segregation study must be significantly lower than the improved time-value of the accelerated cash flow. In other words, the juice must be worth the squeeze, including the audit risk.

Another way to look at Gotcha #2- accelerated depreciation is not extra depreciation. Two rentals, one with a cost segregation study and one without, will be fully depreciated at 27.5 years. As such, it is purely a time-value of money compared to fee consideration. Then again, if you take the tax savings (deferral in reality) and blast off on a fun vacation, that has value too, right?

Gotcha #3. The last gotcha is one that is often overlooked. A cost segregation study and the subsequent big depreciation deduction is a one and done event. The following tax year, your depreciation comes down to earth and is actually less than it would normally be. Keep mind that cost segregation accelerates depreciation; it does not create new or phantom depreciation. Take a $780,000 building that would normally depreciate $20,000 per year. If you accelerate $150,000 in depreciation the first year, years 2 through 39 will be $16,600ish (versus $20,000).

Summary

A cost segregation study, or “cost seg” as your bartender advises, can be extremely beneficial. But there are problems to navigate through, and like Robert Plant used to sing, (not) all that glitters is gold and sometimes words have two meanings.

Another consideration- should you benefit from a cost segregation study and the related big tax deduction, then perhaps pairing this with a Roth conversion on your traditional IRA makes sense as well. Tax planning is a must!

At the risk of repeating ourselves, whether this accelerated rental property depreciation yields a tax deduction / tax benefit and therefore increased cash flow (an improved IRR) is contingent on three general things-

• Short-term rental loophole (7 days average guest stay + material participation), or

• Real Estate Professional designation (REP status), or

• Net rental income (profit) that can be reduced

Go forth and cost seg!