We've seen many people who try to lower their tax liabilities doing…let's say…sometimes shady things. It's frustrating, because we know there are valid ways that it can be done and these ways are often overlooked. Hiding in plain site is a great tax savings tool called Cost Segregation. The technicalities can be found here: www.irs.gov. But that's probably not what you're interested in — you're more interested in how this actually works.
What is Cost Segregation?
Cost Segregation could potentially save hundreds of thousands of dollars, but unfortunately, it is not often used correctly as it requires a team of players. Maybe that's why only about 5% of people that are eligible use it, and use it correctly.
In tax -speak Cost Segregation is an IRS method of "re-classifying" components and improvements of commercial and residential real estate.So what does that mean?
The IRS has fairly arbitrary rules for the deductibility of commercial property expenses. When you buy a commercial property, you can't write the expense off right away. Rather, you are only allowed to "expense" a portion of it per year (land you are not allowed to expense or depreciate.) The portion of how much you are able to deduct each year is determined by the depreciation schedule. Generally we have 5 year, 7 year, 15 year 27.5 and 39 year property (see what we mean by 'seemingly arbitrary'?)
The IRS looks at your purchase of commercial property not as a business expense, but rather an investment that you're going to get a return on. You can only write off 1/39th (or 1/27.5th) of it a year. That's not worth a lot, especially when you consider inflation, and the discount of the future value of money. Wouldn't you rather depreciate sooner than later? (yes, you would).
An Example of Cost-Segregation with Hotels
Most commercial property will have to be updated on a regular basis. Let's use hotels as a for instance.
Think about the updates any (successful) hotel does on a regular basis: restaurants, room renovations, lobbies, landscaping, decorations. Imagine booking a room at a hotel today, and when you get there you realize they hadn't updated it in the past 40 years. You could go to the hotel down the street and pay the same amount of money for a hotel that was updated 5 years ago – where are you going to choose to stay? So you're constantly updating the property, but the tax code is treating you as if you are not. Pretty sucky.
In 1997, both Walgreen's and Hospital Corp of American had enough, and brought their case against the IRS to court. They prevailed over the IRS and Cost Segregation was born, but you sure don't see the IRS advertising the great benefits of it. So now, instead of taking 27.5 or 39 years, you can condense depreciation into 5, 7 or 15 years. Even better news? You can go back in time so you can amend some past years returns…and that could add up very quickly.
Who should consider using Cost Segregation?
For commercial property, it should be worth at least three hundred thousand dollars. The general rule of thumb (but not guaranteed) is about that you will get 10% of property value as a cash injection in the form of tax offsets or even a refund. You should first get a Cost Segregation Study done; this is an engineering report that will tell you if moving forward is worth it to you. When choosing someone to do this study, be wary! When speaking to anyone to see if you would like to hire them, you want to ensure you ask if they have actual engineers on staff. This is the best way to get the correct information.
They should inspect your property and look at things like load bearing vs. partition walls, among a litany of other very detailed information. They can help you understand what can be written off in 5, 10, or 20 years as opposed to 39.5. Professional engineers excel at showing the facts as they are and can provide you a rock solid report.
There are other groups that can also benefit from Cost Segregation:
- Surprisingly, Cost Segregation even applies to US owned commercial property overseas!
- Estates: One of our friends, Peter Burns, recently wrote an article on how this could even help out people who have recently passed.
- Charitable Fundraising
The bottom line is that you want to have a better tax strategy than your competition. Using Cost Segregation, or having a Cost Segregation Study done will NOT raise any red flags with the IRS. If you have any questions or need additional information about using Cost Segregation, or any tax planning, contact us to schedule a free, confidential consultation. Call us at 888-727-8796 or email firstname.lastname@example.org.
IRSMedic, The Law Offices of Parent & Parent, LLP