The Cost Segregation Study: An Overlooked Estate Planning Tool
Owners of commercial and rental residential real estate often use cost segregation studies to accelerate depreciation deductions and improve cash flow. But it might surprise you to learn that these studies also offer significant estate planning benefits. Families that inherit real estate can take advantage of these benefits, but they need to act quickly. A cost segregation study can be performed after the owner dies, but it must be completed before the owner’s final income tax return is filed or else the benefits will be lost.
What is cost segregation?
A cost segregation study applies engineering and cost-accounting techniques to reclassify certain building components as tangible personal property rather than real property. Ordinarily, commercial buildings are depreciated over 39 years, while rental residential buildings are depreciated over 27½ years. In contrast, personal property — such as equipment, furniture and fixtures, land improvements and certain building components — is generally depreciable over five, seven or 15 years.
By reallocating some of the costs of acquiring, constructing or substantially improving a building to these shorter-lived assets, real estate owners can accelerate depreciation deductions, reduce their tax bills and enhance cash flow. Owners can even use a “look-back” cost segregation study to capture missed depreciation from previous years through a one-time “catch-up” deduction in the current year.
What are the estate planning benefits?
Typically, when someone dies, the family’s tax-planning efforts focus on the impact of estate and income taxes on the beneficiaries who receive the deceased’s property. Too often, the family overlooks valuable opportunities to augment the deceased’s wealth by reducing his or her final income tax liability.
If the deceased person owns underdepreciated real estate, a cost segregation study can be used to claim missed deductions on the deceased’s final income tax return, increasing the amount of wealth available to his or her heirs. The following case study illustrates the potential benefits.
On January 1, 2010, Dan buys a rental residential building for $2.5 million and depreciates the entire cost over 27½ years. He dies in 2016, leaving the building to his children. Dan’s executor commissions a cost segregation study, which concludes that $500,000 of the purchase price was properly allocable to five-year property. The executor files Form 3115 with Dan’s 2016 income tax return, claiming a one-time deduction for the depreciation he could have taken in previous years.
The amount of the catch-up deduction is, for purposes of the example, $300,000: the difference between the total depreciation Dan claimed from 2010 through 2015 and the amount he could have claimed had he treated the five-year property as such from the beginning. The bottom line: Assuming Dan was in the 39.6% tax bracket and had enough income in 2016 to offset the deduction, the cost segregation study reduces his final tax liability by $118,800. Paying less income tax will increase the amount he passes to his heirs. Be aware that, even if he’s subject to estate tax, which would erode some of the benefit of the income tax savings, his family is still better off. That is, if he’s in the 40% estate tax bracket the extra $118,800 will, after the impact of the estate tax, still net his family more than $71,000.
Leveraging the stepped-up basis
In addition to reducing a deceased person’s final tax liability, cost segregation studies conducted for estate planning purposes have a distinct advantage over studies conducted in other contexts. Ordinarily, owners who sell depreciable buildings must pay a 25% “recapture” tax on gains attributable to previous depreciation deductions, in addition to capital gains tax. Because recapture taxes reduce — or, in some cases, eliminate — the benefits of accelerated depreciation, owners are often advised not to conduct a cost segregation study if they plan to sell the building within the next five years or so.
Transferring property at death avoids this issue. The recipient receives a stepped-up basis in the property equal to its date-of-death fair market value. If the recipient then sells the property shortly after the death of the owner, the sale may be for no gain and therefore be income-tax-free.
If you’d like to use accelerated depreciation deductions to reduce a deceased family member’s final tax bill, contact your estate planning advisor as early as possible. To take advantage of this strategy, a cost segregation study should be completed well in advance of the filing due date of the deceased’s final income tax return, and any missed depreciation deductions must be claimed on that final return. Once the deadline has passed, the opportunity will be lost.
Sidebar: Catch up on missed deductions with a look-back study
Cost segregation studies are most effective when they’re conducted before, or at the same time as, the acquisition, construction or improvement of the subject real estate. But even if a building was placed in service years ago, that doesn’t mean it’s too late to enjoy the benefits of a study.
A “look-back” cost segregation study enables owners to claim missed deductions without the need to amend previous years’ returns. That’s a big advantage, because the statute of limitations for filing an amended return is only three years. By filing Form 3115, Application for Change in Accounting Method, with the IRS, owners can claim missed deductions going as far back as 1987 and take a one-time “catch-up” deduction in the current year. Keep in mind, however, that the benefits of a cost segregation study will be eliminated or greatly diminished if the subject property has already been fully or mostly depreciated.
To further explore the use of a cost segregation study as an estate planning tool, please contact us.
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