Why Should You Care?
Cost Segregation Study (CSS) allows you to claim 50-70% more depreciation on your commercial property. This reduces your income taxes and in turn increases your cash flow from the property.
What is Cost Segregation Study?
This IRS-defined engineering approach accurately classifies an investment property into two asset groups:
- Structural components which have longer depreciation schedule;
- Non-structural components, eg furniture, carpets, landscaping, plumbing, electrical, HVAC systems, parking lot which have shorter 5, 7, or 15 years depreciation schedule. So the more non-structural components the property has, the more extra depreciation you can claim.
CSS is normally done by an appraiser or an engineering company. The company will visit your property for a site inspection to fully understand its use and condition. It then provides you with a CSS comprehensive report. This report includes pictures and information to support and document the classification of costs according to the strict IRS-approved methodologies. The result of CSS is then given to your CPA or tax accountant for income tax filing.
Without CSS, you will just use the standard depreciation schedule for improvement: 27.5 years for apartments and 38.5 years for other commercial properties. This is the way 90% of investors are doing. So if you have not heard of this term, chances are you are not taking advantage of the higher depreciation the IRS allows you to.
Benefits to Investors
By shifting a portion of the property into the non-structural assets, CSS allows you to reduce your income tax by generating extra 50-75% depreciation tax deductions and thus increase your after-tax cash flow. The extra depreciation basically converts ordinary rental income at your current tax bracket to tax-deferred capital gain when you exchange the property.
Of course the higher your tax bracket, the more tax savings you will get. The saving is even more if you also have to pay state income tax as CSS is also allowed in state income tax return. These tax savings tend to occur in the first 5 years of ownership. Once the extra depreciation runs out, it may be a time to evaluate if you should exchange the property and repeat the whole process again.
CSS allows you to increase tax depreciation. This is not the same as accelerated depreciation which simply shifts a higher percentage of depreciation deduction to the early years. This accelerated depreciation is subject to Alternative Minimum Taxes while depreciation from CSS is not.
Who Can Benefit from CSS?
If you own any of the below, you should be able to benefit from CSS:
- Retail / shopping Center,
- Office building
- Nursing Homes, Assisted Living Facilities
- Hotel / Motel
- Warehouse / distribution center
- Industrial building
- Public Storage
- Auto Repair Shop
- Auto Dealer Property
- Hospital, medical center
- Sport / entertainment Facility
Below are a few companies that do CSS. Most companies will provide you with a free estimate for the CSS of your property. The author does not endorse any company.
- Commercial Cashflow Advisors, (408) 213-2530, ccashflow.com.
- O'Connor & Associates, (800) 856-7325, cutmyfederaltaxes.com
- Source Corp., (817) 732-5494.
Do's and Do not
- If you own commercial property valued at $ 1M or more, you should explore the benefits of CSS especially when you are at high tax brackets and can benefit from additional depreciation.
- Use the Cost Segregation Calculator on CutMyFederalTaxes.com. You just need to provide: property type, building cost, your tax rate, date of purchase and it will give you an estimated tax savings. Use this as a go, no go test to see if it's worth pursuing further.
- Take advantage of free estimate most CSS companies offer. It tells you the costs of CSS, and estimated potential tax savings in the first 5 years.
- Do not let the cost of CSS deter you. It costs money to make more money.
- Discuss the estimate provided by the CSS companies with your CPA or tax accountant to see if your CPA would advise you to proceed.
- You may want to consider CSS at the time of purchase of a commercial property as part of your investment and exit strategy.
- You will maximize the tax savings benefits if you hold the property for 5 years, ie it probably does not make sense to do CSS and sell the property shortly after that.
- If you own the property for several years, the IRS allows to "catch up" underreported depreciation from prior years by filing a form 3115.
- If you have remodeled and renovated your property, CSS can also recover a significant portion of the asset value which you have abandoned.