Debunking the myths of cost segregation

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I hear the comment all the time, “If I do cost segregation, I’ll just give it all back in recapture when I sell.” Allow me to debunk that myth and more.

Myth 1: “If I do cost segregation, I’ll just give it all back in recapture when I sell.”

The extra depreciation is used today to offset ordinary income currently taxed at 12 to 37 percent for individuals; whereas, the recapture, upon sale, is taxed as 15 to 20 percent capital gains rate. The portion of the gain equal to the depreciation would be subject to the 25 percent recapture rate, which is still lower than the rates for most individuals. There’s typically a 10 to 20 percent total arbitrage between the two.

There are two points with this myth:

A. Offset ordinary income today with depreciation and you repay it at either a capital gain or 25 percent rate, both of which are probably lower than the rate would otherwise be.

B. Under the time value of money, you get the use of the tax savings today and don’t have to repay it until the future sale date. We will explore this more below.

Myth 2: “Cost segregation doesn’t work on short-term holds.”

When a property gets purchased, it’s not likely to have enough organic equity without value add or capital expenditure to increase the market value to sell it. When the components are broken out using cost segregation, accurate values are provided for different class lives. Having this detail allows for easy calculation of partial asset disposition, otherwise known as PAD, which is a write-off of the assets removed from the property during renovations and improvements. If PAD isn’t taken, then double depreciation of those assets accumulates, adding undue accumulated depreciation to your books. This will really hurt when recapture gets calculated after the sale. In short, dispositions can help avoid recapture tax. In addition, dispositions avoid the 3.8 percent net investment income tax.

Myth 3: “Cost segregation is only a timing difference.”

This is true, up to a point. If someone won the lottery and had a choice to take either $1,000 per year for 40 years or $40,000 up front, which would they choose? Most people would choose the latter because one could invest that money and make more. If they chose the first option, they would probably spend $1,000 a year on insignificant items like groceries and have nothing to show for it after the 40 years ended. That’s what cost segregation does. It offers the ability to shift depreciation from a 27.5- or 39-year asset to a variety of buckets; three, five, seven or 15 years. Then it uses that depreciation to offset your taxable income and reinvest those funds to update the property to keep it in good working condition—without searching for capital (or hiring new employees.)

Myth 4: “My property is too small for cost segregation.”

It’s surprisingly economical to pursue cost segregation on properties with a basis of $300,000, and sometimes less. It will depend on the need, but it’s certainly worth evaluating on any size property. It’s important to note that the winners for cost segregation are property owners who have held the property for 10 or more years, so they can get a large Sec. 481 adjustment for three, five, seven and 15-year property. However, smaller investors can plan for that large deduction and use it to offset other income and gains, so it can help to increase cash flow for smaller investors. For instance, if business owners sell a business and have a gain, but also own real estate they’re holding for retirement, they could offset the gain from the business sale by doing a cost segregation study.

Myth 5: “Cost segregation is too expensive.”

There is a cost to perform cost segregation; however, if 20 to 40 percent of the building is written off in the first five years, and you are paying income tax, is a couple of thousand dollars worth it? There’s no need to wait until tax season to utilize the benefit from cost segregation. For taxpayers making monthly or quarterly payments, the projected tax savings can be applied to annual projections to reduce these tax payments for an immediate impact to cash flow.

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