Cost Segregation and Its Impact on Recapture Taxes

What is Cost Segregation?

Cost segregation is a widely accepted tax compliance strategy used by commercial real estate owners and tenants to accelerate depreciation deductions, defer tax payments, and enhance cash flow. Initially reserved for major accounting firms and large real estate owners, this practice has now become commonplace for property owners of various scales.

Considered one of the most effective tax strategies for real estate investors, cost segregation has emerged as a top niche service for accounting firms. Whether your assets are newly constructed or acquired, this approach can significantly boost your cash flow and provide substantial tax advantages. Neglecting to employ cost segregation may mean missing out on valuable tax benefits that could greatly impact your financial situation.

When to Conduct a Cost Segregation Study?

Performing a cost segregation study offers numerous opportunities for property owners and investors to maximize tax benefits. This study should be undertaken under various circumstances to capitalize on potential deductions and adjust depreciation. Firstly, it is advisable to conduct a cost segregation study immediately after construction, property acquisition, or substantial capital improvements, including leasehold improvements. Secondly, a change in ownership, such as inheriting property or altering partnership interests, presents another suitable scenario for conducting the study. Additionally, even for buildings already in service, a Look-back study can be conducted to explore untapped depreciation benefits.

One common misconception among property owners and tax advisors is that they cannot make changes once the three-year statute to amend has expired. However, the IRS permits taxpayers to use a cost segregation study to adjust depreciation for properties placed in service as far back as January 1, 1987. Through an adjustment under IRC §481(a), taxpayers can catch up on previously unclaimed depreciation in a single year, based on the difference between actual depreciation and potential depreciation if a cost segregation study had been conducted from the beginning.

The potential benefits of a cost segregation study can be substantial, offering a significant boost to tax savings. The best part is that taxpayers can make these adjustments without filing an amended return. A simple filing of Form 3115 (Change in Accounting Method) with the attached cost segregation study suffices to take advantage of these valuable tax-saving opportunities.

Understanding Recapture Taxes

Recapture in taxation refers to a situation where a taxpayer is required to repay a portion of the depreciation deductions they previously claimed on a property when they sell it at a profit. The tax code mandates this repayment at ordinary income tax rates since the taxpayer had originally deducted the depreciation at those rates. As a result, the taxpayer loses the opportunity to benefit from the more favorable capital gains tax rates on the portion of the gain attributable to the allowed or allowable depreciation deductions.

Impact of Cost Segregation on Recapture

Cost segregation is a method used in the context of 100% bonus depreciation, where accelerated depreciation is front-loaded into the first year through a study. This often leads to substantial deductions that exceed the taxpayer's ability to fully absorb them, resulting in tax planning opportunities and reduced tax liabilities.

Recapture is only triggered in specific scenarios. For instance, it can be triggered by like-kind exchanges, selling a property at a gain, or even selling at an overall loss in certain cases. If a cost segregation study is conducted and the property is subsequently sold at a gain, recapture is likely to occur. The recapture process involves the repayment of depreciation deductions on 1245 assets and 1250 assets at different rates. 1245 assets are recaptured at ordinary income rates, while 1250 assets have more complex recapture rules. If a depreciation method faster than straight-line was used, the excess depreciation over the straight line is recaptured at ordinary income rates, while the depreciation up to the straight-line amount is considered "unrecaptured" 1250 gain and taxed at a maximum 25% rate. Recapture on 1250 assets is common when dealing with Qualified Improvement Property (QIP) or land improvements.

Taxpayers can strategically manage their recapture by limiting it or restricting it to unrecaptured gain. This can potentially lead to tax savings by taking deductions at ordinary income rates and recognizing gains at the more favorable capital gains rates. Utilizing a sales price allocation cost segregation study can be helpful in implementing this approach. Additionally, it is essential to ensure that fixed asset listings are cleaned up before a property sale to avoid recapturing assets that are no longer on the books.

Recapture and Opportunity Zones

In the world of property sales and tax planning, more individuals are exploring alternative strategies to optimize their gains. Traditionally, 1031 exchanges have been a popular choice for deferring taxes, but limitations, such as the strict 180-day deadline for finding replacement property, have led some to seek other options.

Enter Opportunity Zones - a promising tool for avoiding recapture and maximizing tax benefits. By choosing to invest gains into designated Opportunity Zones, individuals have the potential to achieve tax exemption on all appreciation if they meet the 10-year hold requirement. Moreover, depreciation recapture on assets like 1245 or 1250 becomes a thing of the past.

The GOAT.tax Approach

At GOAT.tax, we understand the importance of building strong relationships with our clients. Trust, integrity, and hard work are the cornerstones of our success, leading to partnerships with renowned accounting firms, associations, and Fortune 1000 companies across the nation.

When it comes to cost segregation, we take a different approach. We believe that experience matters, and that's why we exclusively employ seasoned cost segregation specialists. Our team members boast extensive experience, with the majority dedicating 10 to 20+ years to managing various cost segregation projects.

Dedicated to excellence, we maintain an in-house team solely focused on cost segregation. This team comprises architects, professional engineers, CPAs, MBAs, and LEED cost segregation specialists. For each project we undertake, our management team is directly involved, even conducting site visits themselves. We firmly believe that on-site assessments are the most accurate way to evaluate a property, and we adhere to the expectations set by the IRS.

Our national presence sets us apart from the competition. With project managers stationed in major markets across the United States, we offer our services far and wide. Following the IRS cost segregation guidelines ensures that our studies meet their rigorous standards, as outlined in the Cost Segregation Audit Techniques Guide. Additionally, we provide audit defense support for all the cost segregation studies we undertake.