Savvy commercial real estate investors look for every tax advantage they can get in a deal. One strategy that can supercharge your tax savings post-closing is a cost segregation audit. This detailed analysis can help maximize tax savings by reclassifying certain property components into shorter depreciation categories. However, like any financial strategy, it comes with its own set of advantages and disadvantages.
Let's explore the pros and cons of conducting a cost segregation audit after acquiring commercial real estate in Pennsylvania.
What is Cost Segregation?
Cost segregation is an accounting strategy that segregates personal property from real property to accelerate depreciation. While traditional depreciation for commercial real estate typically spans 39 years, a cost segregation study can reclassify specific components of the property, such as lighting, flooring, and landscaping, into shorter-life categories—often 5, 7, or 15 years. This can lead to significant tax savings and increased cash flow.
Example of How it Works:
Let’s say that you just closed on multi-tenant building for $1,000,000. Land isn’t depreciable, so you decide the land is worth $200,000, and the building is worth $800,000. If you depreciate the building over 39 years, your depreciation write-off would be $20,512.82 per year. Assuming a 37% federal income tax rate, that would save you roughly $7,500 in taxes.
Now, let’s say you decide to get a cost segregation study. After completing the study, your advisory team identifies the following costs:
$100,000 of interior fixtures and finishes that can be depreciated over five years
$100,000 of interior fixtures that can be depreciated over seven years
$100,000 of land improvements that can be depreciated over 15 years
Based on the study, $300,000 of the $800,000 building is eligible for bonus depreciation, so 60% of the cost could be written off in 2024. Assuming a 37% tax rate, that would result in tax savings of $72,634 over depreciating the building with no cost segregation (($216,821 – $20,512.82) x 37%).
The Pros of Conducting a Cost Segregation Audit
1. Potential for Greater Tax Savings
Depending on the property’s components, you could see significant tax savings. The example above illustrates the savings. Many property owners find that the upfront cost of a cost segregation study is far outweighed by the potential tax savings over the first few years of ownership.
2. Increased Cash Flow
By accelerating depreciation, property owners can lower their taxable income, leading to a reduced tax bill. This means more cash flow in the short term, which can be crucial for reinvesting in the property, paying down debt, or exploring new investment opportunities.
3. Tax Deferral Strategy
Cost segregation allows property owners to benefit from tax deferral. By reducing taxable income now, you can defer paying taxes until later years, improving your ability to leverage these savings for further investments.
4. Improved Understanding of Property Valuation
Conducting a cost segregation study provides a detailed breakdown of your property's components, enhancing your understanding of its value. This can be beneficial for financial planning, insurance assessments, and future sales.
The Cons of Conducting a Cost Segregation Audit
1. Initial Costs
The primary downside of a cost segregation audit is the initial cost. The amount you pay for a cost segregation study will vary, depending on the size and type of your property and the amount of documentation you can provide. You can expect to pay from $5,000 to $15,000 for a study.
2. Complexity and Time Commitment
Cost segregation studies require a thorough analysis of the property, which can be time-consuming. Moreover, the process involves complex tax laws that may necessitate the assistance of legal and accounting experts, adding to the overall time and expense.
3. Potential for Audit Risk
While well-documented cost segregation studies can bolster your position during an audit, they may also increase the scrutiny of your tax return. The IRS may question your reclassification strategies, and if they find discrepancies, it could lead to penalties.
4. Limits on Deductions
If you are considering a cost segregation study on a rental property, and that activity is considered a passive activity, your tax deduction is limited to $25,000 (passive loss limit). If you earn over $150,000 as a household, your tax deduction might be limited to $0. Yes, you are reading that zero correctly. If you qualify as a real estate professional, then your passive loss limits go away. To be a real estate professional as defined by the IRS and not what you hear at the bar, an individual must spend the majority of his or her time in real property businesses.
5. Depreciation Recapture
Recall that depreciation is a tax deferral. When you sell the property, you have depreciation recapture, and you must pay back the deferred taxes. There is some tax arbitrage here, however, since recapture is limited to 25% where you might have deducted depreciation at a 37% marginal tax rate. You can also escape this gotcha with a Section 1031 like-kind exchange.
Conducting a cost segregation audit following the purchase of commercial real estate can offer significant tax advantages, but it is essential to weigh the benefits against the potential costs and complexities.
If you are considering a cost segregation audit in Pennsylvania, consult with one of Clover Lane Settlement Services' knowledgeable real estate attorneys at Fiffik Law Group to navigate the intricate landscape of tax implications and ensure that this strategy aligns with your broader financial goals.