Many real estate investors now recognize the importance of conducting cost segregation when undertaking a major property rehabilitation.
However, the strategic decision to perform a cost segregation study before or after renovation remains a dilemma. It’s a tax planning challenge that you should approach carefully, as choosing a suboptimal strategy means you’ll leave substantial tax savings on the table.
This post explores when and why to do cost segregation for rehab projects, tenant buildouts, and other value-add renovation projects.
Eligible Property Types for Cost Segregation
Cost segregation enables you to depreciate the shorter-lived components of your property faster.
Therefore, any property with significant Personal Property (furniture, appliances, fixtures, etc.) and Land Improvements (pavings, swimming pools, etc.) is eligible for cost segregation.
The following property types are generally eligible:
- Retail strips
- Office buildings
- Mixed-use developments
- Industrial and warehousing buildings
- Multi-family units and apartment complexes
If your property has a depreciable basis exceeding $300,000 (excluding land), we believe it is eligible for a cost segregation study.
Should You Do Your Cost Segregation Study Before or After Renovation Work?
It’s essential to have a complete record of the assets that existed in your property before undertaking a renovation. Therefore, we recommend conducting a cost segregation study before any renovation work begins.
The case for doing cost segregation before renovation is as follows:
- It helps you establish a baseline: You want to establish the basis for all the original property components, including those you wish to retire. It’s valuable as it enables PartialAsset Disposition (PAD) planning to maximize the write-offs for replaced assets.
- You want a reliable third-party record for the IRS: If you are to maximize write-offs for replaced assets, you want complete documentation from a reliable third party to support your claims. Asset classifications and cost allocations from an engineering-based cost segregation study are more defensible.
That said, a single pre-renovation study is usually insufficient.
To truly capture all the accelerated depreciation you qualify for, you should also perform a second study post-renovation.
When You Should Do Both (Pre- and Post-Renovation Studies)
Because renovations typically add new, shorter-lived assets whose depreciation you can accelerate, it makes sense to do a post-renovation cost segregation study, too.
Therefore, you’ll do both pre- and post-renovation studies when you want to:
- Unlock PAD deductions with a pre-renovation study.
- Accelerate depreciation on newly placed-in-service, shorter-lived assets with a post-renovation study.
We recommend you have the same specialists conduct both studies. It ensures strategy alignment, consistent asset classifications, and overall lower study costs.
Steps to Conduct a Cost Segregation Study Pre-Renovation
The pre-renovation study is a planning tool to help you maximize your deductions. You want an engineering analysis of all existing components that can withstand IRS scrutiny.
The key steps include:
- Documentation gathering and review: Gather all relevant documentation, such as blueprints of the original structure, photos of the “before” condition, and the closing statement to establish the original basis.
- Property inspection and engineering analysis: The cost segregation firm will conduct a virtual or on-site inspection of your property. Using industry best practices and engineering costing techniques, it will classify the property components and allocate costs to them.
- Prepare a PAD-friendly cost segregation report: The cost segregation firm will prepare and deliver a cost segregation report with PAD-ready documentation. It’s for this reason that you should use the same firm for both studies, as it streamlines your tax planning strategy.
Steps to Conduct a Cost Segregation Study Post-Renovation
The second study will rely heavily on renovation invoices and change orders as documentation. It’s vital to keep this in mind when carrying out the renovation so you can acquire and retain all documents that may be required.
The post-renovation study will involve the following key steps:
- Documentation gathering and review: Provide as-built plans as well as documentation for the renovation scope of work.
- Engineering analysis and property classification: An engineering analysis of the newly installed assets will correctly classify them and allocate costs accurately. You’ll have a more accurate picture of the shorter-lived assets that can be depreciated faster.
The cost segregation firm will then prepare and deliver a cost segregation report that you and your CPA can use to prepare your taxes.
Ideal Timing for Your Cost Segregation Study
Generally, you should do cost segregation on a property as soon as you acquire it or place it in service. It allows you to capture more of the benefits of the time value of money that comes with frontloading depreciation.
Nonetheless, the best timing will depend on your unique tax planning strategy. For instance, if your cost segregation tax strategy includes PAD planning, it makes sense to do two studies in two different tax years.
Here’s how:
- Pre-renovation study: Conduct the study in the year prior to doing the renovation and prepare your taxes accordingly. The IRS gets a clean record of the assets in your property before you dispose of some.
- Post-renovation study: The second study segregates the newly placed-in-service assets and accelerates their depreciation. Remember to claim PAD in the tax year you dispose of the assets (which may or may not be the year you do the second study).
That said, you can do both studies in the same year. You’ll just need a tighter documentation trail as the approach may invite higher IRS scrutiny.
Also, even though it is not ideal, you can do a pre-renovation study after undertaking a renovation using a “look-back” cost segregation study. The approach is permissible provided you have reliable records to support your engineering estimates.
Partial Asset Disposition and How It Impacts Renovations
When you undertake a significant property renovation project and dispose of some assets before their recovery periods end, you don’t have to lose that remaining book value.
The IRS introduced Partial Asset Disposition for tax years beginning Jan. 1, 2014, as part of the Tangible Property Regulations (TPRs). PAD enables you to write off the remaining depreciable basis of the disposed of components. It’s a one-time deduction in the year you dispose of the asset.
For clarity, here’s how PAD impacted tax treatment:
- Before PAD: If you replaced, say, an HVAC system, you’d capitalize the new system while continuing to depreciate the old non-existent HVAC system.
- After PAD: You capitalize the new HVAC system and write off the book value of the old system immediately. You can then depreciate only the new system in the subsequent years.
Therefore, conducting a cost segregation study both pre- and post-renovation is strategically sound, especially if the improvements include replacing high-value building components, such as HVAC systems.
Working With a Cost Segregation Specialist
Cost segregation is a powerful strategy to maximize deductions and free up cash to reinvest in your real estate business. However, given its complexity, especially where renovations are involved, you must work with qualified specialists to reduce audit risk.
Here are some considerations to keep in mind:
- The cost segregation methodology: In its Cost Segregation Audit Techniques Guide, the IRS explicitly states that a study by a construction engineer is more reliable than one done by someone without a construction or engineering background.
- Tax preparation by the CPA: Your CPA plays a crucial role in IRS compliance and in the maximization of your deductions. It helps to have a CPA familiar with cost segregation bonus depreciation, catch-up deductions, and depreciation recapture strategies.
At Seneca Cost Segregation, we exclusively conduct engineering-based cost segregation studies because they yield the most defensible reports. Our experienced engineers have performed over 10,200 studies nationwide.
Further, when you work with us, we can offer referrals to our vetted network of cost segregation-minded professionals (CPAs, tax advisors, etc.), should you need them.
Contact us today for an IRS-compliant cost segregation study. We’ll help you align your property renovation project with your tax planning goals.
Frequently Asked Questions (FAQs)
Let’s address some of the common questions we get about cost segregation.
Can a Cost Segregation Study Be Done on Older Properties?
Yes, you can do cost segregation on a property put in service in prior years (not too old).
However, eligibility and the extent of available write-offs depend on the remaining applicable recovery periods of the shorter-lived assets. Specifically, Personal Property (furniture, appliances, etc.) has a 5/7-year recovery period, while Land Improvements have a 15-year recovery period.
Does Property Size Affect Cost Segregation Eligibility?
The IRS has no maximum or minimum size criteria for cost segregation eligibility.
However, from a practical standpoint, the size of the property influences its cost basis. The larger the depreciable basis, the more cost segregation makes sense.
Are Furnished Properties Treated Differently in Cost Segregation?
Technically, eligibility is the same for furnished properties.
The cost segregation benefits, however, are more pronounced as a significant portion of the property’s cost basis will shift to the 5/7-year asset class.
Conclusion
A property renovation can be quite expensive. Fortunately, with the right professionals in your corner, you can leverage incentives given by the tax code to subsidize the exercise.
The two most powerful incentives to leverage are partial asset disposition (PAD) and bonus depreciation. Both require you to have detailed, defensible data regarding the value of your existing and disposed of building components.
With Seneca Cost Segregation, you can ensure that every property component removed and every new asset installed contributes to lowering your tax liability.
Request a free proposal today, and our team will give you an estimate of how much you can save with a cost segregation study. We consistently turn 20-40% of property costs into immediate tax savings.
