Cost segregation: a closer look at an emerging tax planning trend.

• Author: Melillo, Jason
• Position: TAXPLANNING

Taxpayers and their advisers constantly are looking for ways to legally reduce their taxes by implementing planning solutions that will help them to shelter income against tax. In recent years, cost segregation has emerged as a popular method for reducing taxable income for taxpayers with real estate investments or commercial entities with leasehold improvements.

Cost segregation is a process by which the basis of real property is segregated into various asset classes that qualify for shorter depreciable lives resulting in accelerated depreciation and deferred tax.

Cost segregation benefits are usually measured by comparing the net present value of the tax savings using the tax strategy against the net present value of not using it. The highest net present value benefit always is generated if the taxpayer deploys the strategy at the time the asset is placed in service.

When a real estate investor has a cost segregation study performed on a property that was acquired in a prior year, the benefits can seem much more dramatic. A cost segregation study on a real estate property that was placed in service in a prior year is known as a look-back study. The benefit for taxpayers in a look-back study is that the difference between what they actually depreciated and what they could have depreciated had they utilized a cost segregation study are expensed in the current period.

This difference is known as the Sec. 481(a) adjustment and is expensed in one year by employing procedures described in IRS Revenue Procedure 2002-19 and 2004-11.

The current procedures allow a taxpayer to reflect this adjustment on a current return, without amending prior year returns, by filing a Form 3115, Application for Change of Accounting Method.

To use the benefits of cost segregation a taxpayer must have taxable income associated with the real property assets that will be segregated. A taxpayer that already has passive losses associated with a property cannot benefit from increased depreciation on that property unless they have other passive income to offset.

Likewise, if a taxpayer were planning on selling a property in the near future, it's typically not advisable to perform a cost segregation study as the benefits are reduced when property is held for a shorter period of time. However, this should be evaluated on a case by case basis.

SEC. 1031 EXCHANGE STRATEGY

Many tax professionals have found ways to incorporate the benefits of cost segregation into clients' tax...