All commercial income properties depreciate, or lose value, over time.
The IRS allows investors to deduct a percentage of the cost of a tangible asset over a specified period. In doing this, you can permanently lower your property taxes, pay less for property insurance, and reduce the amount you owe in income taxes.
The standard time allowed for depreciation in the commercial real estate is 39 years.
However, there are many parts to a building, and a good portion of these parts depreciate well before the 39 year period, which means these parts need to be replaced.
A cost segregation study is conducted by engineers who assess the property and create a detailed list of all the components of the building. Once these parts are identified, classified, and segregated, you can then claim a more realistic depreciation of 5, 7, or 15 years for those parts that depreciate faster.
A cost segregation study allows investors to save tens of thousands of dollars. Here’s are the ins and outs of how it works, and how you too can benefit from this little-known tax savings loophole.
How Can A Cost Segregation Study Help You?
A cost segregation study can result in significant savings, and sometimes as much as 40% of the cost of the building’s furniture, fixtures, and construction costs can be reclassified and claimed as a tax deduction.
As a bonus, you can also claim depreciation on miscalculated components during past years – particularly the last one or two years before the study was completed.
Who Can Benefit From A Cost Segregation Study?
While a cost segregation study seems like a great idea, it’s not for everyone.
If you plan on holding the net lease property for a short period of time – perhaps because you plan on selling it soon – then the cost of the study might prove prohibitive.
Owners of newly constructed triple net properties should also consider a cost segregation study, as should investors who’ve completed a recent renovation. Surprisingly, you can even complete a study before a property is even built.
How A Cost Segregation Study Works
First, let your accountant know that you’d like to do a study. Ask around to find a reputable firm; a local real estate group, your lender, or your accountant should be able to provide you with phone numbers.
There are six methods that may be used to perform a cost segregation study:
- Detailed Engineering Approach from Actual Cost Records
- Detailed Engineering Cost Estimate Approach
- Survey or Letter Approach
- Residual Estimation Approach
- Sampling or Modeling Approach
- “Rule of Thumb” Approach
Although the IRS doesn’t require one method over another, the IRS does state “there are certain approaches (e.g., studies based on actual costs or proper estimation techniques) that produce more accurate and reliable allocations.”
Before visiting your property for a site review, the engineer will review all blueprints, past appraisals, construction invoices and change orders (if applicable), as well as the general contractor’s application for payment. The engineer will also compare construction costs and estimates with actual costs, in order to quantify any differences.
On-site, the engineer will thoroughly examine the property in order to clarify how each component is used and it’s condition. She’ll take pictures in order to serve as proof in the report as well.
Expect the cost segregation study to cost anywhere from $5,000 – $30,000. And while the site visit won’t take more than a day, it will most likely take several weeks to a month to receive your final report.
Since the study is accepted by the IRS, you can also use it to reduce taxes on the property. If you don’t own a triple net lease property, this could make a significant difference in your profits for the year.
