Most commercial building owners are grossly overpaying federal income taxes because they are not depreciating their property as quickly as they should. A cost segregation study allows property owners to both defer and reduce federal income taxes. When properly performed by an appraiser with expertise in cost segregation, this is a conservative tax planning tool which reduces federal income taxes by properly allocating the cost basis between land, 5-year, 7-year, 15-year, 27.5-year and 39-year property.

Cost Segregation Study Benefits
Benefits of a cost segregation study are substantial, immediate and enduring. Year 1 federal income tax savings are typically at least two times the cost of a cost segregation study. In many cases they are five to fifty times the cost of the study. The present value of federal income tax savings for a property held for ten years are typically at least ten times the cost of the study. In many cases, the present value of tax savings as much as 30 to 50 times the cost of the report. The cost segregation study is only required once. Its cost is not recurring, but the benefits are recurring during the term of property ownership. A cost segregation study can also materially reduce local property taxes by separating real and personal property for newly constructed properties.

Detailed Example
Preparing a cost segregation study requires only a limited time commitment from the owner, perhaps 10 to 15 minutes. This limited commitment of time results in substantial tax savings, which are both conservative in approach and well documented. Some owners believe their accountant is properly segregating components into the proper classifications. Many accountants cannot thoroughly research this highly specialized field to understand the myriad of items which can be segregated and are inadvertently overstating their client’s income tax liability. Furthermore, not obtaining a cost segregation study increases exposure in case of an audit since there is no clear audit trail. A cost segregation study prepared by an appraiser with expertise in land valuation, construction costs and market value clearly documents each of these items. Further, a cost segregation expert can almost certainly sharply increase allowable depreciation.
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Apartment owners can face staggering expenses to maintain apartment communities. The upkeep of even a modest community could involve groundskeeping, unit renovation, and replacements, such as parking lot asphalt and fencing. Another steep expense is federal income tax – and in some areas an additional state tax on income – but through an innovative study known as cost segregation, the depreciation of property components can be used to help lower federal taxes.

Today, more apartment investors, especially those whose occupancy rates are challenged by the nation’s single-family housing, are taking a close look at every possible avenue to lower costs. That’s a frustrating task in the apartment business. One historically underused technique for saving money, in this case saving taxes, is to ensure that all depreciable items are reflected accurately on tax returns.
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By ignoring generous IRS guidelines when establishing depreciation schedules, over 90% of real estate investors are unintentionally overpaying federal income taxes. In addition they are paying federal income taxes earlier than necessary, typically years or decades earlier than necessary. Although these IRS guidelines are relatively new, they provide substantial benefits. Since this is a relatively new issue, many accountants have not integrated the new IRS depreciation guidelines into their practice. Savings for real estate investors are meaningful- exceeding $50,000 to $1,000,000 in the first year. Cost segregation converts income taxed at 35% (ordinary income) to income taxed at 15% (capital gains). Cost segregation also defers payment of income taxes, often for 5 to 10 years.

Effects of higher depreciation

Most real estate investors do not understand the benefits of increasing real estate depreciation. They often ask, “doesn’t increasing my depreciation just mean that I will be shifting taxes from now until when I sell the property?”

This is a popular misconception and the answer is a resounding “no”. There are two benefits of increasing depreciation:

1. Converting ordinary income into capital gains income
2. Deferring income until a gain on the sale of the property is realized.

The conversion of ordinary income into capital gains income has to do with the technical nature of the allocation of the gain on the sale. Many, if not most, accountants initially believe it is simply a timing issue. However, when the mechanics of recognizing gain on sale are discussed, accountants quickly realize increasing depreciation leads to paying taxes at the capital gains rate as opposed to the ordinary income rate.
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