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What is Cost Segregation?

Cost Segregation is the practice of identifying assets and their costs, and classifying those assets for federal tax purposes. Residential dwellings and multi-family properties are depreciated over 27.5 years on a straight-line basis according to current IRS depreciation rules and guidelines. Certain components of this same property can be identified and separated into 5, 7 and 15 year tax lives through the use of an Engineered Cost Segregation Study. Likewise, other commercial property types are depreciated over 39 years on a straight-line basis however, certain components can also be identified and separated into 5, 7 and 15 year tax lives. This allows for a building owner to depreciate the components of the investment over the shortest possible time period.

Advantages of this Engineered Cost Segregation approach include:

  1. Improved cash flow by reducing tax burden.
  2. Creates other investment opportunities by freeing-up tax dollars.
  3. Defers taxes over life of the building.
  4. Allows for “catch-up” depreciation for prior tax years in the absence of a study.

What are the IRS Requirements?

IRS’s Audit Techniques Guide (ATG) was first developed in 2004 for the purpose of defining the approach and methodology a credible Cost Segregation Study should follow. Referring to the “detailed engineering approach,” the guidelines state: “In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation.”

Leading the Cost Segregation Industry AER Group can provide a supportable Engineered Cost Segregation Study that will stand up to the strict scrutiny of the IRS auditors. This applies to properties that are constructed, acquired, expanded, renovated, leasehold improvements, or on the drawing board. The advantages of Cost Segregation have become even more lucrative with the passing of the 2017 Tax Cuts and Jobs Act. AER Group has been performing Cost Segregation Studies for over 30 years with an impeccable track record of supporting our results during IRS reviews and audits.

What is the Effect of the New Tax Law?

Tax Cuts and Jobs Act of 2017 further defined additional allowances within the depreciation system and offers full 100 percent bonus depreciation for properties placed in service after September 27, 2017. This benefit is offered on both existing properties and newly constructed properties and will apply to real estate investments for the next several years, with a stepped phase out ending in 2023. For properties placed in service before September 28, 2017 Cost Segregation offers the similar benefits with bonus depreciation on new properties so, don’t hesitate to consider Cost Segregation on these properties as well. By all accounts, Cost Segregation is one of the most valuable tax strategies available to owners of commercial real estate today.

What Court Cases Affect Cost Segregation?

Court cases evolved in the 1970’s based on depreciation claims when tax players took deductions that the IRS did not agree with or could not rationalize. Since that time and following the Tax Reform Act of 1986 depreciation guidelines became clearer as deductions and methodology were a reflection of both the Cost Recovery System and court cases and revenue rulings. In 2004 the IRS developed the Audit Techniques Guide (ATG) which further defined the approach and methodology a credible Cost Segregation Study should follow.

Over the years these court cases, revenue ruling, and the ATG molded the methodology credible Cost Segregation firms would follow. CS firms that lacked experience also lacked the knowledge of tax, engineering, and accounting, which ultimately lead to making judgement errors in their Cost Segregation reporting.

Cost Segregation ATG – Chapter 6.4 – Relevant Court Cases

Who Qualifies for Cost Segregation?

Any for profit concerns that file a federal tax return including:

Pass Through Entities

  • Partnerships, LPs, LLPs
  • S Corps
  • Certain Trusts
  • LLCs


Cost Segregation + 1031 Exchange?

Two of the most valuable tax deferral techniques used in commercial real estate today include Cost Segregation and 1031 exchanges. Just because the property is classified as a 1031 Exchange does not mean that it will not qualify for Cost Segregation tax treatment. Both of these strategies can be used at the same time on the same property.

1031 Exchange requires a Qualified Intermediary to perform the transaction and ensure the proper closing steps are taken. Investors who are stepping up in the basis of the Exchange normally have no conflicts applying cost segregation techniques to the same property however, depreciation recapture must be considered where investors are holding a 1031 Property for the short term and not stepping up the basis of a future exchange.

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