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Understanding Why Depreciation Isn’t Just An Add-on — Cost Segregation

What is cost segregation? In a nutshell it’s the process by which an investor can increase the amount of total depreciation taken on each investment property. It will deal almost exclusively with the personal property which is part of the real estate. These personal property assets include a building’s non-structural elements, exterior land improvements and indirect construction costs. This is usually the point at which investors begin to glaze over.

Not so fast write-off breath.

Once you fully understand the results of successful cost segregation, you’ll be a fan for life. The difference between what the average investor claims for depreciation and what’s actually available is staggering to most when they see it for the first time. If you want to try it out on your own, go here. I strongly recommend though, that you hire a firm specializing in this process, as the IRS much prefers that approach.

What’s the average? In my experience and in talking with various CPA’s over the years, the average taxpayer claims the normal building depreciation using the schedules requiring a 27.5 or 39 year life. Many will then add a few personal assets to the mix, but not nearly what is available to them.

Take a $500K purchase of residential income property.

Let’s say it was built a couple years ago, and you can support a land value of $100K. This results in the building being depreciated at $14,500 a year. Investors then will add a few items of personal property, depreciated over five years. Let’s say the average runs around $5.5K. They now have $20K in depreciation. At the blended tax rate of 33% state/fed, this results in a tax savings of just under $6,700.

However, if this investor takes advantage of cost segregation, his depreciation could increase dramatically. Typically, the engineers will literally look at every single part of your property. This includes but isn’t limited to driveways, landscaping, exterior stairs, HVAC systems, and on and on. It’s common for them to find roughly 6-20% of the purchase price, including land, in new depreciation. (They often find much more than that.) Using this example that would mean give or take $30K (6%) in additional tax shelter. Let’s forget the puny amount the investor was taking before. Let’s just add up what they found to the building’s figure of $14,500 a year.

Dollars

You now have almost $45K in annual depreciation which results in about $15K in tax savings. That’s huge. And if you bought these units with a low down hoping to break even, you now have an after tax positive cash flow to enjoy. If you put 10% down plus closing costs, the total cash needed to close this property was about $62K or so. You now have a cash on cash return (after tax) of 24%!

Oh sure, now you’re paying attention. :)

This past week I was talking with a cost segregation expert, based in San Diego. He gave me a recent example of an investor who paid his company $9K for an in depth study of a purchase he’d made a couple years earlier. They found an addtional $450K of depreciation! It’s fully documented for the IRS, and the company will defend the investor at no cost, without even asking for travel expenses. Using that client’s blended tax rate, which was 40%, the use of cost segregation found an additional after tax income of $15K A MONTH.

And you can go back in time to benefit from this. You’ll have to file a modification of accounting method with the IRS.

I’ll be talking more about this on my own blog. Pay attention to this opportunity. It’s allowed many of my clients to completely avoid the use of tax deferred exchanges.

Of course, that’s a whole different can of worms, isn’t it?

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  • 24 comments

    24 Comments so far

    1. Brian Brady February 28th, 2007 4:53 pm

      That’s freaky! I just met a guy who does this for a living this past Saturday. He’s an engineer and explained the whole concept to me. I didn’t think there were enough to savings ask you about it.

    2. Jeff Brown February 28th, 2007 4:57 pm

      Most folks are unaware of cost segregation because they don’t have a big enough basis to be solicited by the companies offering the service.

      It’s one of the central building blocks on which many of my clients have been tap dancing around tax deferred exchanges for quite awhile now.

      The cost benefit ratio is astoundingly in the favor of the investor.

    3. Athol Kay February 28th, 2007 6:06 pm

      Okay I give up. I’ll be honest Jeff, I’m one of those eyes glaze over types. All I know is that you pretty much said you can saw a woman in half, put her back together again, and not accidentally kill her in the process.

      I am in awe.

    4. Jessica Beganski March 1st, 2007 6:44 am

      I’m so glad you’re writing about this. Before I was a real estate agent, I worked for a regional CPA firm in CT. One of the partners in my firm specialized in doing cost segregation studies for clients with commerical or residential properties such as auto dealers, manufacturers and apartment building owners. I worked with him to write marketing materials and articles on cost segregation – still, it took me about 2 years to understand what the heck he was talking about.

      Now, I do. By reclassifying certain building costs and depreciating them faster, investors reduce their taxable income, defer taxes and increase cash flow. It’s completely allowable by the IRS (you just have to have qualified people doing the study). This is what I call a no-brainer.

      Here’s a plug for the guy I worked with – Jay Sattler of Blum Shapiro in Connecticut. http://www.blumshapiro.com/services/costsegregation.asp

    5. Jeff Brown March 1st, 2007 8:37 am

      Jessica – It’s ironic you mention a CPA firm as your source for this. It’s my contention accountants are the main reason investors are generally uninformed about this wonderful tool.

    6. Jessica Beganski March 1st, 2007 12:44 pm

      Most CPA firms don’t offer this service themselves and so don’t refer their clients to it. And if a CPA refers his/her client to another CPA firm that’s going to save the client tens of thousands of dollars, guess where that client is going to take their tax work the next year…The key is to find a CPA firm who does the work and has an engineering firm to partner with.

    7. Jeff Brown March 1st, 2007 12:57 pm

      Jessica – That’s been my outlook from day one. They each have their jobs to perform. Thanks

    8. Tom March 1st, 2007 3:35 pm

      Jeff,

      I like the way you presented cost segregation in a way the makes it pretty easy to understand. I wanted to address a few of the comments that have been made, but first let me be upfront and say that I am a cost segregation provider. Jessica hit the nail on the head. Most CPA’s don’t have in-house engineers to do the studies completely and in accordance with the IRS guidelines. Because of this, they don’t pass information about this opportunity on to their clients. However, that’s not all. Most CPAs are either unaware that this process is possible, or do not understand exactly how much benefit is out there. In the end what that means is, building owners are not hearing about cost segregation because they expect their CPA to tell them about these things, but the CPA’s either don’t have the information or do not understand who can benefit.

      Tom

    9. Jeff Brown March 1st, 2007 4:12 pm

      Tom,

      Your observation about CPA’s mirrors my experience. I will say in their defense, that much of the time they’re looked on as knowing every possible tax law in the book, which of course is a fantasy. I’ve always said they’re a little like doctors. If your GP tells you your kidneys need attention, even surgery, it’s not likely he’s doing the cutting.

      But the public insists on thinking their accountant has memorized the IRC. :)

      Thanks for the kind words.

    10. Jaocb March 1st, 2007 4:48 pm

      Jeff,

      I just read your article and had to comment on a few things. For the record, I work for a cost seg firm http://www.bedfordcap.com.

      You should be careful when stating “It will deal almost exclusively with the personal property”. A good cost segregation study will deal with all assets, personal property (5 and 7-year), land improvements (15-year) and real property (27.5 and 39 year). A study that deals only with short life assets (person property) is using the residual approach which is almost always less accurate and not the preferred method in the eyes of the IRS. This approach is definitely more subjective which only opens the door for interpretation. This is not good in the event of an audit. Those of you looking for a good provider should seek out a firm that uses an engineering based approach which addresses all assets. For more on choosing a provider visit France Publications’ Lodging Operator Website. Scroll to the bottom of the home page for a link or search for cost seg. This site contains an article I recently wrote about choosing a cost segregation consultant and includes a list of questions to ask.

      It is also worth noting that while the cash flow benefits can be enormous they are not forever. The front loading of depreciation increases deductions early in the life of the property which allows for significant tax deferral. Later on the deductions will be lower, but who cares. You got your money already.

      Lastly, I’m not sure if you are familiar with this but cost seg can be used with a 1031 exchange if done properly and the circumstance are right. The benefits can be awesome.

      Thanks for taking the time to build awareness. If you ever have any questions about cost seg please feel welcome to drop me a line. jhopper@bedfordcap.com

      Thanks again,
      Jacob

    11. Jaocb March 1st, 2007 4:53 pm

      http://www.lodgingoperator.com/article_archive/2007/February/02-15-07.shtml

      Here’s the link. I wasn’t sure if it would fit.

      Jacob

    12. Jeff Brown March 1st, 2007 7:51 pm

      Jacob – You should be careful when stating “It will deal almost exclusively with the personal property”.

      I agree, which is why the post included this:

      These personal property assets include a building’s non-structural elements, exterior land improvements and indirect construction costs.

      Thanks for the comment

    13. Kevin Boer March 1st, 2007 8:43 pm

      My CPA recommended this method for my investment properties, and while the accounting for it is a complete pain in the you-know-what, the tax benefits are undeniable.

      Unfortunately, since depreciation losses are considered “passive” there’s a limit to their tax benefits for non “real estate professionals.”

    14. Jeff Brown March 1st, 2007 9:26 pm

      Kevin – I strongly recommend you use a third party expert in the field. It’s the opposite of a pain in the you know what. You simply give the report to your CPA…..and smile. :)

      As far as using the write-off on your personal income, I can show you how that is a huge blessing in disguise.

    15. Jacob March 2nd, 2007 6:31 am

      Jeff – Thanks for your reply, I’m glad we agree. But again you failed to mention the structural elements, which is what I was trying to point out. I want to make sure your readers understand – a cost segregation study should also breakdown the structural assets in a building as well.

      While you state “These personal property assets include a building’s non-structural elements, exterior land improvements and indirect construction costs” you do not talk about the buildings structure which is the biggest cost. A study that lacks detail w/ respect to theses costs lumps them together into a single line item. This gives the IRS a big target in the event of an audit. For example: Say your CSS identifies all of the short life assets ($1M) and then dumps the remaining costs of ($2M)into a 27.5 or 39-year life. Now the IRS audits the CSS and disagrees w/ the $2M number. What are you going to do? There are no details to support this number. You’re going to lose. In a detailed study which separately costs the 27.5 or 39-year assets you can make an asset by asset defense. Your chances of losing are much smaller.

      Another point of clarification for your readers. Land improvements (15-year) are not personal property assets.

      Jacob

    16. Jeff Brown March 2nd, 2007 10:55 am

      Jacob – Although I’ve been using CS as a tool for quite awhile, most clients who buy smaller props can’t make use of your services due to price.

      Before writing the post I decided to speak with a few companies new to me. Surprisingly, one of them was your own Mitchell Lardner. He was terrific, but because of the median prices of my clients’ purchases, Bedford couldn’t help. The cost was prohibitive.

      It’s understandable because of the man power/hours needed for each property – regardless of value.

      This post was written with the broadest of brushes in order to keep it simple. The idea was to simply make investors aware of a service which goes widely unused – because most investors don’t have a clue as to it’s existence.

      By filling in the blanks you’ve enhanced it. If you can figure a way for your company to be able to provide service to the smaller investor, you’d be inundated with new business.

      Any ideas? Email me with any ideas. Thanks again Jacob.

    17. Jay Thompson March 5th, 2007 5:26 pm

      Wow, this is a damn good post! Somehow I missed it the first time around.

      So how long until our friends in Congress/IRS rip this little gem out from under our feet?

    18. Jeff Brown March 5th, 2007 8:07 pm

      Athol – Sorry for the delay in reply.

      I wish I could take that much credit, but it’s just a matter of experience and knowledge. I’m the one who should be in awe. How do you do so well listing and selling homes when it takes you 20 minutes to dress just to drive to their home? :)

      Thanks again – and BTW, I’ll be posting on the same subject, in a little more detail this week on my blog.

    19. Jeff Brown March 5th, 2007 8:13 pm

      Jay – Thanks so much!

      The IRS has already lost by shutout when they argued against cost segregation when it first came out. The judge saw their arguments as silly. Here’s one of their silly positions.

      A hospital was the taxpayer trying to use CS. The IRS said the use of CS was really the same as component depreciation, as everything was really just part of the building itself.

      The judge merely asked the IRS if they were seriously arguing that the special phone system was part of the building.

      Case Closed.

      If the gov’t took away the ability to do this you’d hear so many different industries howl, that Congress would cave before the fight started. :)

      Thanks again Jay.

    20. Eric Majchrzak March 29th, 2007 7:22 pm

      Good comments on this site regarding Cost Segregation. To give you all a different perspective, I am the Marketing Manager for a major national Cost Seg Firm affiliated with a Top 100 CPA Firm. We’ve done over 2,000 cost segs in the last several years. Cost Segregation has truly become an ultra competitive industry, where many firms use a low price point to differentiate themselves. As far as our marketing approach, we highlight our solid engineering-based technical approach that has been tested by IRS audits. Also, because of the huge influx of competitors in recent years, our national director decided to write a book on Cost Segregation. It acts as a guide or resource for Cost Seg practitioners in public accounting that wanted to start or improve their existing cost seg practice. We had it recently published by a reputable financial services publisher (a strategic move on our part to differentiate our firm from all the others). For us, marketing a book made sense because we were one of the first firms to outsource our expertise and engineers to other CPA firms and real estate companies nationwide that didn’t have this capability. Private labeling of cost segs is a major niche for us, where we essentially act as back-end support for these firms with the benefits of a dedicated staff of engineers, full technical support, no tax season delays, etc, etc.

    21. Jeff Brown March 29th, 2007 7:28 pm

      >I am the Marketing Manager……

      And I believe you. :)

      Sounds like you’ve found a pretty solid niche. So much of your industry is subbed out, just like you said.

      Thanks for coming over.

    22. Anonymous August 25th, 2007 9:17 am

      Jeff,

      I’ve been shopping CPAs recently and you’re 100% spot on. Some knew the tax codes back and forth but were completely useless in helping me save money by leveraging that knowledge.

      While I’m not using them for the same thing as listed here, I’m still reminded of my old business law professor. He used to try to get us to “READ” the law and not “Read” it. Difference being to truly process what the law meant and figure out how to leverage as opposed to reading it and just repeating it verbatim.

      I thought he was nuts back then, but now I know he was actually quite brilliant. :)

    23. Jeff Brown August 25th, 2007 11:05 am

      Anonymous – There are some CPA’s who do understand it, and can get the job done, but they are very few and far between.

      You obviously found a jewel of a professor.

    24. James February 22nd, 2008 6:04 pm

      My firm also does this, feel free to visit the site and call for a free quote.

      http://www.lighthousecapitaladvisors.com

      Cheers

      James