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Cost segregation services: the benefits and drawbacks of cost segregation

Hiring a team that provides cost segregation services can enable you to speed up depreciation during the first years of building ownership, so freeing up funds for vital company investments.

Cost segregation services are among the most important options for commercial real estate, multifamily housing, and tenant improvement owners to decrease tax burden and boost short-term cash flow.

How Does Cost Segregation Work?

Cost segregation is a highly technical topic, and we feel that only professionals with extensive training should conduct our research.

The majority of Source Advisors’ architects, professional engineers, CPAs, MBAs, and LEED-certified experts have managed cost segregation services for 10 or more years.

And every cost segregation specialist has received extensive training in dealing with customers, collecting the relevant information, and assessing each building to ensure that we find the greatest advantage to which each taxpayer is entitled.

Each fundamental cost segregation service comprises the following:

Pre-qualification and Proposal – Each cost segregation specialist research begins with a thorough pre-qualification procedure in which the scope of work is established and a benefits estimate is prepared.

In addition to the estimate of the benefit, a flat charge quote is also provided.

Request and Gather Data – After the proposal has been signed, our staff will collect and evaluate the information you supply, including construction drawings, invoices, modification orders, depreciation schedules, etc.

Conduct Site Visits and Research – From the bills, we will find any particular reclassification candidates.

In the likely case that the invoice data is insufficient for the full research, we will supplement the invoices with thorough estimates based on the construction designs and property inspection.

The findings will be published in a report containing our methodology, pertinent case law, terminology, property description, photographs, and the complete timeliness of our calculations.

Review – A minimum of three reviews are conducted on each study to assure its correctness and quality.

Finalize the Report – A draft report is then produced, and the taxpayer and their CPA are consulted to validate the cost segregation specialist’s assumptions and results.

Once all queries have been answered and the report has been modified, the final report is distributed.

Audit Support – If a study is audited, the highly skilled cost segregation management team that you employ should give audit support through appeals.

Cost Segregation Advantages and Drawbacks

As you are already aware, cost segregation is the approach employed by real estate investors since it offers them substantial tax benefits through quicker depreciation deductions and simpler write-offs when an asset becomes outmoded, damaged, or destroyed.

The benefits of cost segregation greatly outweigh the downsides because cost segregation is the crown gem of real estate transactions.

Advantages of Cost Segregation

With Slower Depreciation Techniques Deductions can be Spread

Not leading to bigger depreciation deductions is one of the main advantages of cost segregation, but take note that this is not going to include the depreciable basis that has been allocated away from the land element of the purchase.

Instead, the benefit of these front-loaded reductions will be quantifiably larger than if the deductions were spread out over longer periods using slower depreciation techniques.

Unused tax base can be deducted

One more advantage of cost segregation is that the remaining tax basis can be deducted if a building component has to be replaced in the future. For example, in a cost segregation study, it was determined that the original value of a roof is $500,000.

The roof will need to be redone two years later when the property’s tax base has been adjusted to $480,000.

A taxpayer is eligible to deduct a $480,000 loss, so if the taxpayer had not undertaken the cost segregation analysis, the conclusion would have been drastically different; no loss could have been made since the roof’s tax basis and the building’s tax basis would have remained linked.

There can be a reduction in local realty taxes

Local property transfer taxes can be reduced when employing cost segregation because local governments are usually assessing these fees that are based on the fair market value of the property.

The transfer tax paid is going to be reduced since a cost segregation study reduces the value of the building, thus also resulting in a possible reduction in annual real estate taxes.

Cost Segregation Drawbacks

There are various flaws in the cost segregation technique, and these are some of the disadvantages when employing cost segregation:

The actual cost of an engineering study

The cost of a typical cost segregation study, as well as a written report, is between $10,000 and $25,000, even though expenses fluctuate.

Cost concerns include the property’s location, whether the structure is new or old, the property’s residential or commercial nature, and the needed completion time.

A cost segregation study must be finished in 4 to 6 weeks after its original commissioning so that the business entity can claim the expense of the research under Internal Revenue Code section 162.

The future sale of the real estate acquisition will almost definitely trigger the recapture rules of the tax legislation

Section 1245 of the Internal Revenue Code applies to tangible personal property; therefore, the taxpayer must report regular income, which may be subject to the maximum marginal tax rate.

Moreover, as IRC section 1250 applies to real estate, the recapture will not be eligible for installment sale treatment, instead, the gain must be recognized under section 1250 which is taxed at 25%.

Those who abuse cost segregation or get erroneous data in their engineering report are going to be subjected to sanctions

Internal Revenue Code section 6662(a) levies a 20% fine on any tax underpayment arising from a “substantial value overstatement.”

A value overstatement happens when the valuation is 200 percent or higher than the amount judged to be the proper amount under Section 6662(e)(1) of the Internal Revenue Code.

This penalty, however, is not applicable if the overvaluation does not result in a large understatement of taxes which is a misstatement of more than $5,000 under IRC section 6662(e)(1), unless the taxpayer can establish the justifiable reason and good faith under IRC section 6664(c)(1).

Some taxpayers are cautious to implement cost segregation since they perceive it as a high-risk tax shelter, but the truth is that this concern is unwarranted. Cost segregation is no more aggressive than an IRS-approved depreciation approach if the cost of the elements in the engineering report is accurately represented.

If you have the right experts on your side, establishing cost segregation will not be stressful. A certified tax expert is all that is required to guide you through the procedure and help you assess if it’s appropriate for your home.