What is Cost Segregation?
Essentially cost segregation is a reclassification system that allows you to consider different parts of a piece of real estate differently. Now clearly raw land is all the same but add a building and things get more complicated, by a mile.
I thought maybe it was me but having now spent way too much time researching the topic I realize it is not just me. The law around this topic is extensive and confusing.
You see as a real estate investor, or a business person who owns real estate, or even dramatically improves a piece of real estate, such as a rented commercial building that is then fitted out by the renter for their own use, you are allowed to write off part of your expense each year for depreciation.
That is understandable; buildings get old and have to be dramatically repaired or replaced. The tax code allows you to write them off at 1/39th per year.
But clearly some parts are going to need to be replaced more often than that. Think hotel carpets for example: clearly wear and tear and even the need to rejuvenate a hotel o a regular basis means they are not going to last 39 years. Amazingly the government recognizes that and allows you to write them off perhaps over 5 years or maybe 15 years.
Now of course this is where it gets complicated. Because sometimes ceilings, just for example. can be written off over 5 years and sometimes over 15 years and sometimes they can only be written off over the 39 year term allocated to building structures themselves.
This is where a Cost Segregation study comes in as engineers who understand the tax code really well can come into your building and determine, after some examination if and which part of your ceiling, for example, can be written off over 5 years, or 15 years or 39 years.
The trouble is that over the years that sort of determination on all kinds of different parts of a building’s interior have been litigated, and now you also need to know what the courts have said the tax code means.
The most complete discussion that I found was this article which you can go and read for yourself.
From this article I found this intriguing piece of information
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COST SEGREGATION CAN PROVIDE REAL ESTATE purchasers with tremendous tax benefits from accelerated depreciation deductions and easier write-offs when an asset becomes obsolete, broken or destroyed.
urchasers of real estate can gain tremendous tax benefits by using a popular asset depreciation technique called cost segregation. Using this method, buyers view a real estate acquisition as consisting not only of land and buildings but also tangible personal property and land improvements. The tax savings come from accelerated depreciation deductions and possible easier property write-offs. A taxpayer can use cost segregation when constructing a building, buying an existing one, or, in certain circumstances, years after disposing of one so long as the year of disposition still is open under the statute of limitations (see revenue procedure 2004-11).Clearly the savings are substantial!
However, this admonition has been issued by the IRS
In a chief counsel advisory (CCA), however, the IRS warned taxpayers that an “accurate cost segregation study may not be based on noncontemporaneous records, reconstructed data or taxpayers’ estimates or assumptions that have no supporting records” (CCA 199921045).
I have copied Exhibit 1 in its entirety just to give you some idea of the complexity we are discussing
| Exhibit 1 : Some Property Improvements Pass Muster | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||
In Hospital Corporation of America v. Commissioner , the Tax Court permitted use of the cost segregation technique for these building improvements.
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Sample Cost Seg Study for a Fictitious Dentist
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Cost Segregation in a Picture