Increase the rate of return with cost-segregation study

Joseph Larkin, CCIM, MCR
Senior associate, Marcus & Millichap

A cost-segregation study is a strategic planning tool that commercial and investment real estate owners can use to increase their cash flow, improve their tax position and improve their overall after-tax return on investment.

These cost allocation studies assess a taxpayer’s real property assets and identify a portion of those assets that can be treated as personal property. By segregating personal property from the real property, the study reassigns costs that would have been depreciated over a 27.5-year or a 39-year period to asset groups that have a shorter cost recovery life. Once this is done, the accelerated cost recovery may, under certain circumstances, be expensed immediately.

On average, 20% to 35% of a real estate investment may be reclassified into tax class lives of five, seven or 15 years. This means much larger tax deductions for cost recovery are available in the early years of the investment than otherwise would be available with straight line depreciation over 27.5 for residential or 39 years for nonresidential. This can result in a substantially lower tax liability and an increase in after-tax cash flow and return.

Recent tax law changes made two simple modifications to bonus depreciation that will make cost-segregation studies more valuable to long-term ownership of commercial and investment real estate. Real estate that has been placed in service after Sept. 27, 2017, is eligible for 100% bonus depreciation treatment through tax year 2022.

Bonus depreciation is a tax incentive that allows individuals and businesses to immediately deduct a certain percentage of their asset costs the first year they are placed in service rather than deducting them over the “useful life” of that asset. This bonus depreciation, which also is referred to as “additional first-year depreciation deduction,” allows real estate investors to increase their tax deductions, thus increasing their after-tax return.

Any assets that are reclassified as personal property will be eligible for bonus depreciation and can be immediately expensed in the first year. This means that an investor acquiring an investment property and performing a cost-segregation study may have a lower initial investment because of the tax savings during the year of acquisition.

Consider the following example: A taxpayer purchases a building for $5 million. After performing a cost-segregation study, the study reclassified 20% of the acquisition cost to be personal property. By assigning these assets a shorter depreciable life, the taxpayer could apply bonus depreciation and write off $1 million of the $5 million purchase price in year one. A taxpayer in a 25% marginal tax bracket would save $250,000 in taxes, or 5% of the purchase price.

Now is a good time to evaluate all your real estate assets. A cost-segregation study does not have to occur in the year of the acquisition. The study could be performed on a property placed in service in a prior year where a tax return has already been filed. This is known as a look-back study.

A look-back study allows you to claim a catch-up depreciation tax deduction. The catch-up, taken in a single year, is equal to the difference between what was taken a depreciation and what could have been taken as depreciation if a cost-segregation study had been performed. The Internal Revenue Service allows taxpayers to use a cost-segregation study to adjust depreciation on properties placed in service as far back as Jan. 1, 1987.

There are drawbacks to the use of a cost-segregation study. On disposition, any asset that is converted to personal property will not qualify for 1031 exchange and may be subject to tax at the taxpayer’s ordinary income tax rate. In addition, all cost recovery that is taken is subject to recapture.

Almost all taxpayers who plan to hold their commercial and investment real estate over the long run can benefit from a cost-segregation study. A cost-benefit analysis of the study should be completed by a competent professional along with a comprehensive review of the individual tax situation with a tax adviser.

As you consider acquiring commercial or investment real estate, both short- and long-term goals should be considered; however, always start your analysis with an exit strategy. Cost segregation typically is beneficial over the long term.

Cost segregation can reduce the owner’s income tax liability, increase the property’s cash flow and enhance the after-tax internal rate of return that the property generates. To help with the analysis, investors should engage qualified professionals with expertise in this to help them decide if the benefits will outweigh the costs.

Featured in CREJ’s June 3-16, 2020, issue

Edited by the Colorado Real Estate Journal staff.