A cost segregation study can help reduce taxes by analyzing the expenses and depreciation of a property since its purchase. But it can be hard to immediately apply the results of a cost segregation study if your properties are not tied to entities with active income and losses. The passive activity grouping election (SEC 469) allows you to group entities that rely on each other, like a property you self-rent to yourself for operating a business, in order to apply passive income and losses come tax time. Here’s how it works and when we recommend using the grouping election and a cost segregation study.
How does a cost segregation study work?
The purpose of a cost segregation study is to analyze and classify a building’s assets in order to assign optimal depreciation schedules for tax purposes. Cost segregation studies are normally conducted by a team of tax advisors and building engineers, also known as CSSPs (Certified Cost Segregation professionals). This team will analyze:
- Property records
- Original purchase price and value
- Cost and details of any improvements
And may even visit the property to visibly assess the components that summate its value. The cost segregation team will then determine the cost breakdown of each building component and assign each a 5 to 39 year depreciable life. The final result is a report detailing the full study with process documentation, site images, cost and depreciation analysis. This report is then used by a CPA to correctly report and depreciate a property to maximize income tax savings.
When should you do a cost segregation study on your property?
A cost segregation study can be conducted on a property at any time, as soon as a tax opportunity is identified. You can request a cost segregation study just after purchasing a property or on a property you’ve owned for years. The tax benefit of a cost segregation study can be felt in a few scenarios. The simplest applies when you directly offset the rental income from that property with your giant depreciation deduction. Once you offset that rental income, it pushes the activity into a loss scenario. This loss is passive for most taxpayers and can only offset other passive income from other rentals or K1 investments. This leaves a lot of taxpayers with large passive losses that carryover and don’t save taxes immediately. One important exception applies where there can be a grouping election done between the real estate and an operating business with common ownership. This is a self-rental situation where you rent the building to your operating business.
While you can do a study at any time, we often say the best time to do a study is when you purchase a property that you also actively have business operations in. In this scenario, you can use any accelerated deductions in the tax year you purchased the property. When you choose to apply the results of your cost segregation study is very important. One year may create a passive loss that has to be carried forward versus the next year having the deduction fully offset other income sources. Consider the situation of buying a commercial rental, leasing to a third party in Year 1 and moving your own business into the building in Year 2. The cost segregation would create a passive loss in Year 1, but it would give you an active loss in Year 2 (if you meet the grouping election criteria).
How much does a cost segregation study cost?
The cost varies widely based on the type and size of property, but we typically advise that a property have a basis of at least $500,000 to justify the study. 15%-20% of that value is allocated to land which is not depreciable. The remaining value likely will not give you a tax benefit high enough to warrant the cost of conducting the study if your basis doesn’t exceed $500,000.
Do residential or commercial properties benefit most from cost segregation studies?
The biggest difference between residential and commercial properties in a cost segregation study will be the depreciable lives assigned to the property components. Qualified Improvement Property (QIP) only applies to non-residential buildings. This makes commercial buildings more attractive for cost segregation studies. If a commercial property is purchased more as a shell building and minimal improvements are made to its assets, then the depreciable lives assigned to the property’s assets may not be as beneficial. In this case, you would focus on the buildout and take advantage of the accelerated depreciation on the direct money you spend versus the original lump sum purchase of the building.
How does a grouping election help you maximize the benefits of a cost segregation study?
When filing your taxes in any year, you can make an election to group a passive rental activity with your active business operation happening within the property. Consider the situation where an attorney owns a commercial building and his law firm leases it directly from him. If he owns 100% of both the rental and the law firm, he can make a grouping election. This election is then irrevocable and must be applied every following year. By making the grouping election, the real estate entity can be considered active for tax purposes.
Without the grouping election, the attorney has an active operating company for their practice and a passive real estate activity for their building. Any losses from a cost segregation study on the building in this instance would be limited to passive income since the real estate business is considered passive. If the attorney decides instead to make a grouping election and combine their operating company (active) with the real estate company (passive), this would render both entities active. This allows the accelerated deductions from the cost segregation study to be used against the active business income versus only being used against passive income with significant limitations.
In the above cost segregation study example from KBKG, in Year 1, the attorney would have increased deductions of $152,246 resulting from the study. If the attorney did not make a grouping election, those deductions could only be used against passive income and therefore significantly limited. If the attorney decides to make the grouping election, the entities are then considered active and the accelerated deductions from the cost segregation study are not limited to passive income only. If the attorney’s combined federal and state income tax rate is 40%, they would have tax savings of $60,899 in Year 1 alone thanks to the grouping election. Therefore, the cost-benefit of the cost segregation study already pays for itself in Year 1. In the next year, the attorney would have accelerated deductions of $238,095 which would lead to tax savings of $95,238. In just two years, the attorney would save over $150,000 in taxes.
What types of entities can you group?
Entities set up as individuals, S-Corporations, partnerships, trusts, and estates can utilize the grouping election. Whether there is reasonableness for a grouping election depends on all the relevant facts and circumstances of the entities as well as the appropriate economic unit. This is defined in IRS Publication 925 and can be narrowed down to five primary factors:
- Similarities and differences between the types of business entities
- Common control
- Common ownership
- Geographic location, and
- Interdependence of the activities
When is it not advisable to group entities for tax purposes?
It is not advisable to group entities if any of them have significant suspended Passive Activity Losses (PALs). Unfortunately, these losses are not freed up when the election is made, only losses generated in the taxable year the election is made and going forward can be deducted. In addition, if one of the entities is sold, the PALs related to that entity are not freed up at the time of sale as it would be if the entity was not grouped. Again, once the election is made, it is an irrevocable election and must be made every year.
Cost segregation studies can pay for themselves with the right property and tax strategy. They are also powerful evidence and analysis to have in the case of an IRS audit on a valuable property’s depreciation schedule. If you think a cost segregation study or grouping election could help you save money on your property and business entities come tax time, schedule an appointment with us today.