Cost segregation: a genuine tax savings strategy.

• Author: Lerman, Jerry L.
• Position: Real estate depreciation

In any economy, real estate owners and investors are attentive to the smallest swings in their internal rate of return. In an economic downturn, savvy owners and investors seek out every opportunity to enhance the bottom-line. Formal cost-segregation studies may accomplish this, as they can produce depreciation deductions of significant benefit.

Although cost-segregation studies had been a key tool in a property valuation arsenal for more than two decades, Congress specifically prohibited component depreciation under the Tax Reform Act of 1986. Faced with this restriction, taxpayers became reluctant to take any action that resembled component depreciation. However, in Hospital Corporation of America (HCA), 109 TC 21 (1997), HCA prevailed in its allocation of personal-property classifications, creating fresh interest in the tax-planning possibilities of this approach. In the ensuing five years, knowledgeable tax professionals have been fine-tuning cost-segregation studies to save significant tax dollars for clients that own or lease real estate.

What Is a Cost-segregation Study?

Practitioners have been doing depreciation analyses for years, identifying specific items like carpeting, appliances or landscaping, and accelerating their depreciation under modified accelerated cost recovery system standards. However, such a depreciation analysis is not cost segregation. A cost-segregation study acceptable under IRS standards is an extensive review that analyzes a property's construction to isolate its structural elements. Taxpayers can depreciate components that are not part of a building structure over shorter time periods. Moreover, a cost-segregation study also considers a property's "soft costs" (such as architect and engineering fees) to determine their allocation.

Example: Taxpayer N owns a multi-family rental property that cost $18 million to build. Under the standard method of depreciation, this total would have been depreciated over 27.5 years. Under an accelerated method, 15% of this amount is attributable to personal property (depreciable over five years) and 5% to land improvements (depreciable over 15 years). By carefully examining construction documents and plans, however, the amount attributable to personal property is determined to be 20% of the total cost, and the land improvements an additional 13%. As a result, the taxpayer realizes $940,000 cashflow from tax savings from the additional depreciation deductions in the first five...