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The IRS Position on Cost Segregation

BACKGROUND

“In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned.

Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property is typically separated into individual components or asset groups having the same recovery periods and placed-in-service dates to properly compute depreciation.”

What The IRS Says About Cost Segregation

The following is a direct quote from the IRS Audit Techniques Guide for cost segregation. It is clear that the IRS states, “to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset…”

The primary means of “determining the proper recovery period” is by conducting a cost segregation study. The purpose of a cost segregation study IS to identify the value of assets with varying lives, typically 5, 7, 15, 30 and 40 for real estate.

Cost Segregation – Supercharged by 2017 Tax Cuts and Jobs Act

Cost segregation has long been very attractive to many real estate investors. The 2017 TCJA magnified the benefits by allowing ALL 5-, 7-, and 15-year life property to be depreciated in year one. Therefore, it is typical for 20 to 50% of the total cost of the real estate to be depreciated in year one.

Examples Before and After 2017 Jobs Act

Let’s consider a standard commercial office building with a depreciable basis of $4,000,000 purchased in September of 2019. The investor is in the 37% tax bracket. Before the Tax Cuts and Jobs Act the depreciation resulting from a cost segregation study would have looked like this:

Without Cost Segregation (Straight-Line)

Commercial Office Building
Depreciation Potential Tax Savings at 37.0%
First Year $29,915 $11,069
Five Years $440,171 $162,863

Use of a cost segregation study would have significantly enhanced his tax and cash flow position as follows:

Without Cost Segregation (Straight-Line)

Commercial Office Building
Additional Depreciation Potential Tax Savings at 37.0% After Tax Fee Return on Investment
First Year $135,884 $50,277 $3,150 16.0 to 1
Five Year $640,854 $237,116 $3,150 75.3 to 1

After the passage of the Tax Cuts and Jobs Act of 2017, and with the utilization of cost segregation, take a look at the difference:

With Cost Segregation (including TCJA)

Commercial Office Building
Additional Depreciation Potential Tax Savings at 37.0% After Tax Fee Return on Investment
First Year $1,187,055 $439,210 $3,150 139.4 to 1

Over $1.1 million in additional depreciation in year one!!