IMGCAP(1)][IMGCAP(2)]When one dies owning commercial or rental residential real estate, a cost segregation study can be a highly effective tool for reducing the estate’s tax burden.
Upon death, the beneficiary receives a step up in tax basis to fair market value of the property, and any recapture tax the decedent would have paid upon sale is forgiven. Using cost segregation to accelerate deductions on the pre-stepped up basis provides a windfall of immediate income tax deductions that are never recaptured on sale. To take advantage of this strategy, however, the estate must act quickly: The study must be conducted and implemented before the extended due date of the decedent’s final income tax return.
Typically, buildings are depreciated over a 39-year period (27.5 years for residential property). A cost segregation study applies accounting and engineering principles to identify building components that qualify for depreciation over shorter periods (usually, five, seven or 15 years).
Note that cost segregation studies generally don’t increase the amount of depreciation deductions over a property’s life. Rather, by accelerating these deductions, they enhance current cash flows and generate net-present-value savings. In addition, under Section 481(a) of the tax code, owners may be entitled to significant “catch-up” deductions to capture missed depreciation from previous years.
When used in an estate-planning context, a cost segregation study can substantially reduce or even eliminate taxes owed on the decedent’s final federal income tax return. It also avoids a potential disadvantage of cost segregation studies performed during life: the recapture tax “whipsaw.”
Generally, when property is sold, the owner must recapture previous depreciation deductions (25-percent rate for real property and ordinary rate for personal property). For this reason, it generally doesn’t pay to conduct a cost segregation study on a property that will soon be sold, because recapture taxes will likely erase the benefits of accelerated depreciation. But in an estate-planning context, a building owner’s heirs receive a stepped-up basis in the property equal to its fair market value on the date of death. This enables them to turn around and sell the building free of recapture taxes.
Case Study
Suppose that Frank owns two rental residential buildings that he bought in 2008. After deducting the value of the land, the buildings have an unadjusted depreciable tax basis of $1.5 million, with $1,147,755 of depreciation remaining. Frank also owns several other rental properties that are fully depreciated and generate significant cash flow with minimal deductions to offset income taxes.
Frank dies on August 31, 2016, leaving the buildings to his daughter, Annette. His final federal income tax return, which is due April 17, 2017 (October 16 if extended) shows a tax liability of about $300,000.
Frank’s executor arranges a cost segregation study for the two buildings, and the study identifies $206,875 in missed deductions. On Frank’s final federal income tax return, his tax preparer uses IRS Form 3115, Change of Accounting Method, to make a Section 481(a) adjustment claiming the missed deductions. Assuming Frank’s blended federal and state tax rate is 45 percent, this results in a permanent tax savings of $93,093.
Annette receives the buildings with a full basis step-up to fair market value, and begins the depreciation process all over again. She can even have the cost segregation study updated, for a nominal fee, to reflect the buildings’ current value and condition.
Timing is Everything
A cost segregation study need not be performed before a building owner’s death, but it’s critical to complete and implement it before the decedent’s final tax return is filed. Generally, a study’s benefits can’t be claimed on an amended return, so if an estate misses the deadline, any catch-up deductions will be forfeited permanently.
To preserve the potential benefits of this strategy, it’s important to identify the opportunity early and to work with a reputable cost segregation firm that has experience implementing this estate-planning strategy.
Gian Pazzia, CCSP, is a principal with
