Debunking Cost Segregation Myths

Uncovering the Truth Behind the Tax Saving Strategy

When it comes to optimizing tax strategies for businesses and real estate investors, there's one concept that stands out: Cost Segregation. This financial tool can provide remarkable benefits by accelerating depreciation and ultimately freeing up more cash in your pocket. However, as with any financial strategy or tax advice, there are misconceptions and solutions to be found. My aim here is to pull the curtain back and reveal the true side of cost segregation to help you understand what is true from false.

1. ?Misconception: The Dreaded Audit Risk

This misconception is admittedly one of the most frequently heard around cost segregation. The common misconception that property owners might harbor about cost segregation is the fear of attracting an IRS audit or that the simple application of cost segregation illicits an audit.

Solution: Qualified Professionals at Your Service

Engineering-based Cost Segregation studies have been upheld as appropriate and valid since 1997, and no riskier than any other legitimate deduction. It is good practice to abide by the guidelines set forth in the tax code for conducting these studies. To alleviate the fear of audit make sure you vet out your cost seg provider. This can be a daunting task, especially if tax regulations and IRS protocols aren't your expertise. Review multiple firms or ask your CPA/ tax advisor if they are familiar with and trust a certain provider. Navigating the waters of cost segregation can be smoother with the assistance of qualified professionals. There are many experts who are well-versed in IRS guidelines and protocols. The engineered-based approach is the preferred method by the IRS and ensuring compliance with the 13 points specified in the tax code is a good start to engaging with a cost seg provider. Some firms even offer additional audit support in the unlikely event should the study be reviewed. As a business owner and real estate investor, it becomes imperative that you research and find a quality provider to perform the tax-saving analysis, but keep in mind the very act of conducting a cost segregation study is not illegal or will trigger an audit.

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1. Misconception: Depreciation Recapture Dilemma

Another common concern in the realm of cost segregation is depreciation recapture. The worry here is that when a property is sold, the IRS could recapture the accelerated depreciation claimed through cost segregation. This recaptured amount is subject to your regular income tax rate, which often exceeds the capital gains tax rate, potentially leading to a higher tax liability upon sale.

?Solution: Long-Term Strategy for Smart Decisions

The key to managing the concern of depreciation recapture is to plan strategically. If you plan on holding the property for an extended period, the benefits gained from accelerated depreciation can often outweigh the potential tax liability from recapture. Remember, the value in cost segregation is the time value of money. The same concept applies here. It's all about assessing your property holding duration and tax implications. Furthermore, there are several exit strategies that can mitigate or defer the taxes by means of a 1031 exchange, deferred sales trust and even seller financing. As always, it is important to council with tax experts to apply the right strategy for your specific situation.

• Situations will vary of course, but if you plan to hold your multifamily family property for at least 3-5 years, the increased cash flow from the accelerated depreciation generally more than outweighs the increased tax from recapture.??
• Asset dispositions are shielded from related recapture. Look to PAD elections to reduce a property’s basis.?
• Improvements that are expensed immediately under the Tangible Property Regulations will decrease the recapture burden later at the time of sale.??

1. Misconception: Sticker Shock - Study Costs

Cost is another aspect that frequently raises eyebrows in the context of cost segregation studies. Conducting these studies demands a deep understanding of tax law, construction methods, and specific industries, making them seemingly expensive. If a physical person needs to visit my property and document it, surely this is going to drive the cost up.

?Solution: Weighing Costs Against Benefits

Before diving into a cost segregation study, it's crucial to weigh potential tax advantages against the study's cost. It's a common misconception that the upfront cost might not be worth it. However, a well-executed cost segregation study can unlock substantial tax savings, often exceeding the study's initial cost. A good way to understand the costs is simply asking your provider how costs are associated with the project. Additionally, as an investor, your main focus should be on the return on investment (ROI). Does the tax savings from the study reward me enough from the cost associated with performing the study? On average, the industry can see between a 25:1 – 50:1 ROI. Study fees vary, but once again, the industry average is typically $2,000 - $12,000+ depending on property value and type. Another added benefit is the cost of the study is tax deductible and yes, while only a portion of the fee may be written off, it is good to note that the amount you pay for the study should be sent in with your end-of-year taxes for the refund. Lastly, most firms will provide a complimentary preliminary analysis that offers a glimpse of potential tax savings before you fully commit.

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1. Misconception: Study Complexity is Overwhelming

The complexity of cost segregation studies can be another stumbling block. Property owners, especially those who aren't well-versed in this area, might find themselves overwhelmed by the intricacies or processes involved.

Solution: Leverage Expertise for Clarity

It’s no lie, performing a cost segregation study is difficult and it should be. Every property and asset varies and needs to be carefully inspected by the right professionals. Just as a General Practitioner may understand the cardiovascular system, they are not going to perform open heart surgery. To overcome the complexities, it's advisable to bring in professionals who specialize in tax law, construction methodology, and your specific industry.

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1. Misconception: Partner Conflicts

When a property is co-owned by multiple partners, the tax savings from the study can not be divided amongst the partners.

?Solution: Open Lines of Communication

Clear communication among partners is a powerful tool for resolving conflicts. All partners should be on the same page regarding benefits, risks, and costs associated with a cost segregation study. Partners are able to collect their share of the tax savings.

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1. Misconception: Cost Segregation is Only for Large Properties

One common misconception is that cost segregation is only beneficial for large commercial properties.

?Solution: Advantages across a wide range of properties

The truth is that cost segregation can be advantageous for a wide range of property sizes and types. Even smaller properties as low as $200,000 can still benefit from identifying shorter-life components that can be depreciated faster.

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1. Misconception: Cost Segregation is a Tax Loop-Hole that cancels out my taxes for life

Some individuals mistakenly view cost segregation as a loophole that allows them to avoid paying taxes entirely. (Tik Tok claims)

Solution: Short-term tax relief

It's important to understand that cost segregation is a legal and ethical strategy. When conducted correctly, it aligns with tax regulations while helping you take advantage of available depreciation deductions. It doesn't eliminate taxes; rather, it accelerates the depreciation of certain components, providing short-term tax relief.

1. Misconception: I acquired my property in a 1031 exchange, so I can't do a cost seg study

I have heard this one personally too many times to count. These two strategies go hand in hand. It's understanding the limitations of deferring capital gains in conjunction with deferring tax liabilities.

Solution: Cost Basis

Cost segregation studies are often used in conjunction with a 1031 Exchange as deferring the capital gains from a previous property is advantageous to cash flow. It is imperative to note that the replacement property has a cost basis that allows for accelerated depreciation. This is where the confusion arises. When performing a cost seg study on a replacement 1031 property, the capital gains from the relinquished property must be taken out of the replacement property's cost basis. Meaning if I sold a $2 million dollar MF complex and purchased another $2 million property. If my capital gain was $1 million, then the replacement property would have a cost basis of $1 million instead of $2 million to perform the cost seg study on. Unfortunately, the tax code does not allow us to double dip and accelerate depreciation on the capital gains that are being deferred. Added benefit, if the replacement property has the same amount of Section 1245 assets as the relinquished property, you may be able to defer/avoid Section 1245 recapture tax.

1. Misconception: My accountant already does cost segregation for me

Most likely, probably not... While your CPA is highly qualified in their line of work there is a plethora of additional tax-saving strategies like Section 179, NOL carryforward, etc. that your CPA can apply on their own. Cost segregation is a niche practice that requires qualified engineers and partners to perform tasks that produce significant results that can pass the scrutiny of the IRS. Most accountants either outsource the work or, more often, refer the client to a company that specializes in cost segregation.

Solution: Two heads are better than one

It never hurts to have a review of your tax strategy with your CPA and cost seg provider. We do not replace CPAs and instead make their lives easier and their clients happier by facilitating a tax strategy that ultimately saves their clients thousands, sometimes millions in taxes! As the old saying goes, two heads are better than one. At no fault to the accounting industry, but most tax-saving strategies for businesses and real estate investors are not taught in the curriculum. If your CPA is unsure of cost segregation or never heard of it, most firms have internal tax advisors that can speak to the legitimacy and tax advantages of cost seg on a level they will understand.

In Conclusion: Embrace the Potential

Cost segregation can be a game-changer for property owners, leading to substantial tax savings. While its complexities might seem daunting, each challenge can be met with a tailored solution. I encourage property owners to explore the benefits of cost segregation and see firsthand how the benefits may fuel business and real estate growth. With guidance and expertise at your side, this strategic move can significantly enhance your financial standing.

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