From Carr, Riggs & Ingram, this is It Figures: The CRI Podcast, an accounting, advisory and industry-focused podcast for business and organization leaders, entrepreneurs, and anyone who is looking to go beyond the status quo.
Hello, internet world. My name is Geoffrey Cover, and I am a consulting partner out of the New Orleans Office of Carr, Riggs & Ingram, CRI. I’m here today to talk to you about cost segregation and other engineered tax benefits that you might be able to use in your tax planning, either after you’ve acquired real estate or if you’re considering acquiring some real estate for either your business portfolio, for business purposes, or strictly for investment purposes. To kick it off, I think the best way to start this conversation is discuss what cost segregation is at its most basic. It is a complex product to develop. However, it’s a fairly easy tool for taxpayers to utilize to help defer tax liability.
What is a cost seg study? A cost seg study primarily exists to help allocate out the assets that are inherent to real property. This is your buildings and other pieces of real estate. What it serves to do is to take that real property and to identify all the components that build up that property, so the drywall, the carpets, the tiles, the roof, all the components that are either permanently attached to the building or are what are deemed non-permanent portions of the real property.
What we do is we take that building and we take it apart into all of its various components, so we can identify each and every one of those individual items that make up that building, and then take a position for tax purposes that is favorable for depreciation deductions. At its most basic, we’re just taking a building. We’re identifying every part of that building, we’re assigning it a value, and then we’re looking at the tax code and we’re saying what is the most favorable position we can take for you, the taxpayer, so you can accelerate your deduction opportunities on that property.
Why is this important to you, the taxpayer? Well, when you purchase this real property, the IRS Code requires that you place this property as a capital asset on your balance sheet, which means you have expended money or entered into debt to acquire a piece of real estate that you do not get to deduct immediately. In fact, the IRS requires that you deduct that real property either over 39 years for commercial property or 27 and a half years for residential property. Now, what does this mean for you, the taxpayer? That your deduction is going to be recognized equally over that life period, meaning you will only get to access 1/39th or 1/27th and a half of that asset’s value any given year.
Now, typically, most taxpayers are in a position where that real property is generating income in excess of that depreciation deduction in any given year, and the ability for that taxpayer to access some of that basis, we’ll call it, which is the value of the depreciable part of that property, will give them the opportunity to defer some taxes in the current period by accelerating this depreciation into the current year or into a shorter life, let’s say five years, seven years, or fifteen years, thus giving you access to offset your current taxable income quicker than you would if you had simply placed the assets on your balance sheet at 39 years or 27 and a half years.
Now, for tax planning purposes, we always believe it’s important to distinguish that this is not a tax avoidance technique. You’re going to recognize 100% of that depreciation eventually once you’ve realized the entire life of that asset, once again, either 39 years or 27 and a half years. However, since you’re recognizing that depreciation in the current period or in the current five years or forward-looking, ten years, fifteen years, et cetera, you’re going to accelerate that deduction now and defer some of your liabilities into the future.
Now, since most taxpayers and most investors work with the concept of the present value of money, being able to avoid that tax liability today because you’re accelerating that deduction into the present is worth more to them, because they’ll have access to that capital in the form of taxes that they would’ve paid had they not entered into a cost segregation study.
The next common question I typically get for cost segregation studies is what do they look like, what is the reality for a taxpayer, because the exercise of taking a large piece of real property and identifying the value of every component of that property, the quantity in cost that comprise every component, seems like it’s very laborious for the client. A lot of taxpayers are hesitant to enter into anything that’ll put more work on their plate, given that they’re already trying to run their business enterprise, look for future growth opportunities, plan themselves personally, et cetera.
I do want to dispel some rumors around this. This is actually very easy for a taxpayer to enter into and achieve the benefits of. Most of the work around the cost segregation study stays with the CPA and the engineer who perform the work. It is a fairly easy product, actually, for a taxpayer to enter into, and the tax benefit savings can be extremely taxpayer-favorable.
The process generally looks like this. Once a target opportunity is identified, and a cost segregation expert has reviewed the property and determined that it is going to be taxpayer-advantageous to pursue a cost segregation study, at this point in time the taxpayer either furnishes the CPA and the engineer on the cost segregation side with whatever available documentation they have to support the cost segregation study … this can be plans, design specs, everything from detailed mechanical and HVAC, plumbing and electrical drawings, to something as simple as appraisals and site visit layouts … at which point the engineer then takes it on our side, and we utilize a cost estimating technique to rebuild the property on our end.
Meaning for the client, the process simply looks like providing all the initial support necessary and/or access to the property for our engineers to get in and rebuild the property based off of their measurements, the components that they identify, and their review of whatever documentation is available. We like to say the process is fairly black-box when it comes to the product, as we take all the information in, typically a very, very easy request list for a client to furnish, and then we do all the work on our end. Then we’ll bring it back at a drafting stage to go over with management or whoever’s most familiar with the property, to affirm that the building as we have identified it is reasonable based off of the taxpayer’s understanding. It’s actually a very, very easy product on the client’s end. All the challenges are on our end.
Another common question I receive as a cost segregation expert is what properties are the best properties. What properties are the most favorable properties for taxpayers to look for when determining if they would like a cost segregation study? My initial response is, there is no bad property. Let a cost segregation expert review your property and the facts and circumstances around it, and provide a free benefits estimate based on their review of the property and their inherent knowledge, having worked in the real estate space so long, of what the benefits of that type of property would be.
If you have a garden-style apartment complex, we’re familiar with the typical benefits that we see from those style properties. If it’s a commercial strip mall versus an office building, or if it’s simply a single-family home investment property, we can provide you with what we believe the anticipated tax deferral opportunities will be. Based off of that, we’ll advise you whether we think it’s advantageous for you to move forward from a cost benefits standpoint, or if we think that the property is just not going to create enough value for the cost of the study.
This being said, if you wanted some rules of thumb that would be good to stand by, a tax basis somewhere between 500,000 and 750,000 as a minimum is a good floor for a full cost segregation study. This is simply due to the fact that the residual basis that is pulled aside from the allocation of assets to favorite categories is usually not enough to justify the cost of the study. How long you’ve held that property as a taxpayer is important. If you’ve held this property for 10 years or so, you’ve already recognized a quarter of the life of the asset from a depreciation standpoint, and the remaining basis is small enough that it’s possible that a cost segregation study will not be advantageous.
Both of those things said, if you’re not sure and you want to receive a free estimated benefits analysis, reach out to your CPA or reach out to us directly, and we’d be happy to review the property and determine whether or not we think it’s going to be a good target for a study, as well as at the same time provide you a quote for the services, so you understand what your anticipated tax deferral opportunity might be as well as the cost you’re going to incur to have the study completed.
Let’s take a minute and talk about depreciation. For the last four or five years, depreciation has gotten a lot of news because it’s been such a taxpayer-favorable environment for utilizing deductions that maximize depreciation expense and/or investments that allow access to the depreciation deduction, namely real estate, and real estate has always been a great tax planning tool because of the depreciation it generates as well as the general strength of it as an investment.
Let’s talk about depreciation specifically. Not to get too technical, but in 2017, the Tax Cuts and Jobs Act was passed, and with the Tax Cuts and Jobs Act, bonus depreciation was put back into place, and was in fact put back into place extremely favorably. For the last few years, we’ve been in an environment where we could recognize 100% of the value of any asset with a life under 20 years immediately in the current period. This is what was known as bonus depreciation, and at its base, bonus depreciation is simply an election to take an asset class and accelerate the deduction into the current period. In the past, we’ve had 30% bonus depreciation periods, we’ve had 50% bonus depreciation periods.
Well, the Tax Cuts and Jobs Act gave us 100% bonus depreciation, and then doubled down and gave us 100% percent bonus depreciation not on only new assets, but any used assets that were acquired from another partner or asset holder. Historically, bonus depreciation has simply been set aside for new assets placed in service for the first time. The act of allowing used property to get access to this supercharged real estate as a depreciation generator gave a significant number of taxpayers the ability to defer taxes simply through the acquisition of real estate or the construction in place in service of real estate, and the cost segregation study that would give them the appropriate lives to take the election.
Now, the bonus depreciation environment is changing a little bit, and I do want to make taxpayers aware of this. As for the last few years, we have had the environment of 100% bonus depreciation starting for tax years ending in 2023, so your December 31st, 2023 filing will have only 80% bonus depreciation instead of the 100% as the program starts sunsetting, reducing each year by 20%. This said, it’s still an extremely favorable environment to acquire real estate and/or to utilize a cost segregation study to access some of that depreciation deduction.
Now, a frequent question I do get from taxpayers, or a frequent misconception that taxpayers have, is that this is an election that has to be made in the year that you either have placed the property in service or acquired the property, and then seeking a cost aggregation study on a property that was placed in service on a tax return two or three years ago is something that would require the taxpayer to amend that return and open it for statutory purposes in the eyes of the IRS. I’d like to correct that now.
This is actually a benefit that can be taken in the current period without amending your prior return, which means taxpayers can review their portfolio of not only investments that they’re making in real estate or purchases they’re making in real estate in the current period or the open tax year, but they can also look back to prior periods on their tax asset details or discuss with their CPAs and look at their portfolio and say, “Hey, what real estate have I entered into in the past, and does it make sense for me to look at that real estate to access some of that depreciation today? It does not require me as a taxpayer to amend that return and open that return again. I can simply take it in the current year,” as long as you file the appropriate tax filings associated with that catch-up depreciation.
We call them look-back studies because we’re looking back into prior tax periods, and we’re identifying assets that have the potential to have great value from a cost segregation standpoint, performing a study, and then recognizing the benefits of that study in the current period. Which can be very powerful for a client, especially if they’re in a position where three years ago when they bought that piece of property, they did not have a tax liability.
Now that that property is income-generating … and I say purchased that property, that can also be new property placed in service … but now they’re here three years later and for whatever reason, they’re now in a position where they do owe taxes. They’re making more money. They have other investments that are generating income. Maybe it’s in a partnership and there’s additional income that’s rolling up, or maybe simply that property is now at a position where it is cash flowing fully because it’s now fully leased up or rented, and there is taxable income.
Well, you can go back to that property, access that depreciation today, and then utilize it to defer today’s taxes further into the future. It is a very, very strong tax planning technique. It simply requires discussion with your CPA and coordination with the cost seg provider to see which properties are the best targets and how that will interact with your current tax position.
Now, as cost seg providers, and you’ll find this with cost seg providers across the market, but any reputable cost seg provider will get this question fairly frequently. “We acquired a strip mall, we acquired a building, we acquired a hotel. The hotel is a number of years old. It is new to us, the taxpayer, but it is a used piece of property, and unfortunately to time, the plans and the drawings and the specs have been lost.” Now, either the prior owner did not communicate them over with sale and they’re unable to go find the plans and the specs and the drawings, or simply, due to time they’ve been lost. Maybe they were simply manual plans, before plans were regularly digitized and filed away.
We’re approached and they’ll say, “Well, we’d love to do a cost segregation study, but we’re unable to provide the plans and support necessary to give you, for you guys to review the property. Is this an issue? Are we still able to do a cost segregation study in this instance?” We’re very happy to be able to say that, yes, that is absolutely no problem at all. There is not a requirement that plans be available. Obviously, if there are plans available, it will assist us in identifying the property.
If there are no plans available, no drawings, no specs, or if those plans are incomplete or if they’re a bit old, or if they’re just a pair of manual plans that have been sitting in the basement for the last 20 years and nobody’s looked at them, any of those scenarios, a cost seg provider can come in with their team of engineers and still be able to perform a quality study simply by performing an in-depth, thorough site visit, reviewing the property as it sits at that day, reviewing any improvements made to the property over time, and then being able to rebuild that property using standard costing means as that property would’ve been initially constructed.
It is a huge misunderstanding that I believe a lot of taxpayers have, is they immediately discount their ability to claim an engineered based tax study simply because they do not have those plans. That is false. An engineer can still come in and do a quality study that’ll be supportable in the eyes of the IRS. It simply might mean a little bit more time for the engineer onsite with you, the client, or a maintenance manager or whomever has access to the property, to perform the procedures necessary to identify all the assets. Even if you don’t have the plans, it is completely fine. It is very, very common in acquisition scenarios for the plans not to be communicated.
We’re more than happy to review the property as it is and communicate the challenges we might have, and whether or not we believe we’ll be able to perform a study with the information we have. Once again, if it’s a piece of real estate, regardless of the state of it, as long as it’s being recognized on your tax return as a real asset, there is a possibility that a cost segregation study is favorable. Reach out to your cost seg provider. They’ll help consult with you for free to identify whether or not this is a great opportunity.
To recap, any piece of real estate could be a good target for a tax deferral opportunity and a cost segregation study. The act of having real estate means you have access to potential depreciation deductions that you just haven’t accessed yet as a taxpayer. Utilizing a cost aggregation study will give you the access necessary to take that depreciation, accelerate it to a more current period, as well as support your position if the IRS ever wants to review how you identify the value of those components.
Once again, I would like to thank everybody for joining me here today in this discussion for cost segregation. I realize the topic itself may not be terribly exciting, but truly the benefits and the tax deferral opportunities here are very, very, very good, and those in and of themselves are exciting. Consult with us, consult with your CPA. Reach out to us for a free estimated benefits analysis and quote for services, and you’ll see the actual benefit that comes from these studies is truly exciting, as it gives you, the taxpayer, access to some cash and capital that you would otherwise be you to using to pay taxes.
It’s a great tax planning technique. It’s a great way to open up that global cash flow, and it’s a great way to utilize the assets that you’ve invested so heavily with to strategically tax plan around. Thank you again for joining me here. Please reach out if you have any questions, and have a great day.
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