The Details
Cost Segregation
Cost segregation is an impactful tax incentive for real estate investors. Let's take a deeper dive into topics that impact the value to you.
The Details
Unlock Hidden Value in Your Real Estate Assets
At Acena Consulting, we believe in building relationships based on trust and delivering excellence in every engagement. Our team of cost segregation experts goes beyond the surface to uncover significant tax savings opportunities within your residential and commercial real estate investments. With our in-depth knowledge and commitment to integrity, we'll help you maximize your returns and achieve your financial goals. Lets's take a deeper dive into several advanced cost segregation topics that impact the value a cost segregation study can bring.
In this section we will unpack detailed information about
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The Real Estate Professional
Real Estate Professional Status: Unlocking Tax Advantages
At Acena Consulting, we're dedicated to helping real estate investors like you maximize profitability and minimize tax liabilities. Understanding your status as a real estate professional is crucial for achieving these goals. It directly impacts how rental real estate losses are treated and whether your real estate income is subject to the net investment income tax.
Unlocking Deductions for Real Estate Professionals
Typically, losses from rental real estate are considered passive and can only offset passive income. However, if you qualify as a real estate professional, you gain a significant advantage: the ability to deduct these losses against your other income sources, such as wages or business income. This can substantially reduce your overall tax burden.
Do You Qualify? The Two-Part Test
Achieving real estate professional status requires meeting two key criteria:
- More than half of your personal services in all trades or businesses must be dedicated to real property trades or businesses in which you materially participate.
- You must perform over 750 hours of services within these real property trades or businesses where you materially participate.
What Counts as a Real Property Trade or Business?
The IRS provides a broad definition of real property trades or businesses. It includes activities such as:
- Development and redevelopment
- Construction and reconstruction
- Acquisition and conversion
- Rental, operation, management, and leasing
- Brokerage
What is Material Participation?
Material participation goes beyond passive ownership. It demands consistent, regular, and substantial involvement in the operations of your real estate ventures. The IRS offers seven tests to determine if you meet this threshold:
- The 500-Hour Test: You participate in the activity for more than 500 hours during the tax year.
- The Substantially All Test: Your participation constitutes substantially all of the participation of all individuals in the activity.
- The More Than 100 Hours Test: You participate for more than 100 hours, and no other individual participates more than you.
- The Significant Participation Test: You participate in multiple significant participation activities exceeding 500 hours in total.
- The 5-of-10-Year Test: You materially participated in the activity for five of the past ten years.
- The 3-Year Personal Service Activity Test: You materially participated in a personal service activity for three prior years.
- The Facts and Circumstances Test: Based on all facts and circumstances, your participation is deemed regular, continuous, and substantial.
Navigating the Net Investment Income Tax
A 3.8% net investment income tax may apply to some rental income and gains from real estate. However, a valuable safe harbor exists for real estate professionals who meet specific material participation criteria, potentially exempting them from this tax.
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1031 Exchanges & Cost Segregation: A Powerful Synergy for Real Estate Investors
As an owner or CFO of an innovative middle-market company, you're constantly seeking strategic advantages to drive growth and maximize returns. At Acena Consulting, we understand your drive for efficiency and proactive solutions.
We want to introduce you to a powerful combination: 1031 exchanges and cost segregation.
1031 Exchanges: The Basics
A 1031 exchange allows you to defer capital gains taxes when selling a property and reinvesting the proceeds into a "like-kind" replacement property. This means you can keep more of your capital working for you, fueling further investments and expansion.
Types of 1031 Exchanges:
- Delayed Exchange: The most common type, where you sell your relinquished property first and then acquire the replacement property within the specified timeframes.
- Simultaneous Exchange: A less common and more complex type, where the relinquished and replacement properties are exchanged at the same time.
- Reverse Exchange: You acquire the replacement property before selling the relinquished property. This provides more flexibility but has stricter rules.
- Construction/Improvement Exchange: You use exchange funds to make improvements to a property you already own or to build a new property.
Key Requirements (for all types):
- Like-Kind Property: While this sounds restrictive, "like-kind" is broadly defined. You can exchange almost any type of real estate for another (e.g., an office building for raw land).
- Timelines: You have 45 days from the sale of your relinquished property to identify potential replacement properties and 180 days to complete the acquisition of the replacement property.
- Equal or Greater Value: The replacement property must be of equal or greater value than the relinquished property.
- Qualified Intermediary: A qualified intermediary must hold the proceeds from the sale of your relinquished property and use them to acquire the replacement property.
Cost Segregation: Amplifying the Benefits
Think of cost segregation as a magnifying glass for your depreciation deductions. By conducting a cost segregation study on your replacement property, you can unlock significant tax savings and boost cash flow, further enhancing the benefits of your 1031 exchange.
How Cost Segregation Works:
- Identify and Reclassify: We analyze your property to identify building components that can be depreciated over shorter timeframes (5, 7, or 15 years) rather than the standard 39 years for commercial property.
- Accelerate Depreciation: This reclassification allows you to take larger depreciation deductions in the early years of ownership, reducing your taxable income and increasing cash flow.
- Maximize Tax Savings: By combining cost segregation with a 1031 exchange, you can defer capital gains taxes and significantly reduce your ongoing tax liability.
Example:
Let's say you exchange a fully depreciated property for a replacement property worth $5 million. A cost segregation study identifies $1 million worth of assets that can be depreciated over 5 years. This could result in hundreds of thousands of dollars in tax savings over the first few years of ownership. Depending on the bonus depreciation rules in place at the time of the exchange, this can be amplified dramatically for the personal property identified in the cost segregation study.
Why This Matters to You:
- Fuel Growth Initiatives: Reinvest the increased cash flow in R&D, new product launches, or expansion efforts.
- Enhance Your Portfolio: Optimize the tax benefits of each property in your portfolio.
- Gain a Competitive Edge: Maximize tax efficiency and free up resources to invest in your team and improve customer experiences.
"Acena was a pleasure to work with from start to finish. The entire team was both responsive and knowledgeable as we navigated the cost segregation process for the first time. I cannot recommend Acena enough for this service."
Improvements, Repairs, and Dispositions
Introduction
One of the benefits of owning real estate is the ability to take advantage of depreciation. The purchase or construction of a building results inthe asset being capitalized to your balance sheet and, over time, depreciated. Depending on the type of building, commercial or residential, the straight-line depreciation will be computed based on a 39-year (commercial) or 27.5-year (residential) asset life. As the building is depreciated, an expense is included against rental income that lowers taxable income. Remember, this depreciation is a non-cash expense that lowers taxable income but does not require a direct payment. Additional money spent to improve the property is also capitalized and depreciated.
As an example, if a rental property generated $25,000 in rental income and had operating expenses of $15,000 (mortgage, interest, utilities, property taxes, etc.), without depreciation, taxable income and cash in hand would be $10,000. Taxes at 37% for federal income tax would leave the taxpayer with $6,300 in cash. However, when we include an additional $5,000 of depreciation, the cash in hand before taxes is still $10,000, and the cash in hand after taxes increases to $8,150 ($25,000 less $15,000 operating expenses & $5,000 depreciation = $5,000 taxable income less $1,850 income taxes (37%) ).
Through cost segregation, the amount of depreciation can be dramatically increased, reducing taxable income to zero. The result is a cash in hand of $10,000 for the taxpayer with no taxes due.
Improvements or Repairs?
Real estate owners must make repairs and, in many cases, improve their properties. Whether the money spent is a repair or should be classified as an improvement is critical as it impacts budgeting, cash flow, and taxes. A repair can be expensed immediately, which reduces taxable income by the total amount of the repair. An improvement must be capitalized and depreciated over its useful life (unless it can be expensed through bonus depreciation). This means a real estate owner will pay for the cost of the improvement and can not reduce taxable income by the amount spent. So, how these purchases are classified can make a significant impact on taxable income and cash flow for the year. To better understand how to classify an expenditure for an improvement or repair, we need to better understand the definitions of both.
Safe Harbor
Let’s start with the safe harbor rules to eliminate a few variables. Several safe harbors are available to determine whether an expense is a deductible repair or an improvement that must be capitalized.
- De minimus safe harbor election: A taxpayer may elect to treat expenses that have a useful life of less than 12 months and are less than $5,000 for a unit of property (Reg Section 1.263A-1(f)) as a repair.
- Remodel/Refresh safe harbor election: Specifically for retail and restaurants for expenses related to refreshing, remodeling, repairs, maintenance, or similar activity (REv Proc 2020-25)
- Safe harbor for small taxpayers to deduct building improvements: the lesser of 2% of the unadjusted basis of the building or $10,000 for a taxpayer whose average gross receipts over the prior three years are less than $10M.
- Routine maintenance safe harbor: Routine maintenance is the amount paid to keep the building structure or system in normal operating condition and can be expensed fully.
Improvements
Money spent to improve a property must be capitalized and depreciated over the useful lives of the improvements. Some improvements are structural and would be depreciated over the life of the building (27.5 years for residential buildings and 39 years for commercial buildings). However, some improvements, such as cabinets, countertops, interior windows, carpets, and many others, can be depreciated more quickly due to asset and class life characteristics defined in the Internal Revenue Code.
An improvement, as defined in the IRS Repair Regulations, is the amount paid for the
- a betterment to the unit of property;
- restoration of the unit of property; or
- adapting the unit of property to a new or different use.
This brings up a few questions that we can unpack;
What is a Unit of Property?
What is considered a Betterment?
What defines a Restoration?
When do we consider something an adaptation versus a repair?
Let’s break these down individually.
Unit of Property
Generally, the unit of property for a building is the entire building including its structural components. However, under the tangible property improvement rules, the unit of property analysis applies to the building structure and each of the key building systems. Specifically, the building systems are defined as;
- Plumbing System;
- Electrical System;
- HVAC System;
- Elevator System;
- Escalator System;
- Fire protection and alarm system;
- Gas distribution system;
- Security systems.
Betterment
Amounts paid for the betterment of a unit of property are those that correct or fix a material condition or material defect that existed prior to acquisition or arose during the production of the unit of property.
While the regulations do not define “material,” several examples are provided to help understand conceptually the term.
Example
Angie acquires land with a leaking underground storage tank left by the previous owner. Costs to clean up the land are an improvement because the correct a material condition or defect that arose prior to the acquisition.
Restoration
An amount restores a unit of property if it:
- is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss, other than a casualty loss;
- is for the replacement of a component of a unit of property for which the taxpayer has taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
- is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss,
- returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
NOTE: The definition of restoration differs from routine maintenance in the key fact that restoration requires that the unit of property has deteriorated to a state of disrepair and is no longer functional.
Adaptation to a new or different use
An amount paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property when the taxpayer put it into service.
Disposals
Amounts spent to improve a property typically result in building components being disposed of as part of the improvement process. As an example, improving a kitchen typically requires the removal of flooring, countertops, cabinets, appliances, electrical, plumbing, etc. The cost of these assets can be valued and taken into account as an expense on the tax return.
However, to value the assets being disposed of, a cost segregation study should be performed to properly allocate the cost of each item before it is disposed of. Pictures of the assets prior to demolition and pictures of the completed improvements are helpful for documentation of the assets disposed of and added to the property.
Tax Planning Opportunity
From a tax planning perspective, the expense related to the disposal of these assets will increase the overall depreciation taken in the year the improvements (and dispositions) are placed in service.
An experienced engineer with knowledge and understanding of building systems and construction should complete a cost segregation study. The study should also take into account assets that have been removed and disposed of to capture the maximum amount of depreciation and expense.
A quality cost segregation study has 13 specific criteria listed by the IRS in its Audit Techniques Guide. At Acena Consulting, our cost segregation study meets all the IRS criteria and is backed up by audit defense as part of our engagement. For more information on a quality cost segregation study, please see Quality Cost Segregation Studies.
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IRS Criteria for a Quality Cost Segregation Study
Quality Cost Segregation Study: Principal Elements for Success
Introduction
A cost segregation study allows property owners to reclassify certain assets, accelerating depreciation and leading to significant tax savings. While there is no standard format, all cost segregation studies should aim to classify assets correctly, explain the reasoning behind their classifications, and provide accurate substantiation of costs. These key factors help ensure the study meets IRS guidelines and stands up to audit scrutiny.
What Defines a "Quality" Cost Segregation Study?
A quality cost segregation study is well-documented, accurate, and comprehensive in detailing asset classifications and costs. The more thorough the study, the smoother the review process will be for all parties, minimizing audit risks. A high-quality study shares a number of key characteristics, outlined in the 13 principal elements below.
Principal Elements of a Quality Cost Segregation Study
1. Prepared by an Individual with Expertise and Experience
Typically, a study conducted by a construction engineer is considered more dependable than one performed by an individual lacking engineering experience or a construction background. Moreover, expertise in cost estimation and allocation, along with familiarity with relevant tax laws, are crucial qualifications.
A quality study always identifies the preparer and always references their credentials, experience, and expertise in the cost segregation area.
2. Detailed Methodology
A quality study consistently outlines the methodology employed and specifies the steps undertaken to classify assets and ascertain costs.
3. Appropriate Documentation
A high-quality study relies on current documentation to categorize assets and establish costs. The supporting documentation may differ based on whether the property is new or pre-owned and whether original construction documents are accessible.
4. Interviews with Key Parties
Conversations with contractors, subcontractors, taxpayers, and property managers play an essential role in understanding the property's specific use and the construction processes involved. A quality study meticulously records all these interviews with relevant parties, enhancing the study's depth and accuracy. However, it is important to note that obtaining details about subcontractor work can be challenging since taxpayers often have no direct interaction with them.
5. Common Nomenclature
Using confusing or inventive terms to describe property items, instead of straightforward and well-understood terminology, diminishes the study's quality. Such descriptions might obscure the actual nature or function of an asset (for example, calling a building's sewage or water piping system "process piping" or labeling an emergency exit sign a "decorative placard").
A quality study consistently employs terminology that aligns with the blueprints and other project documents (such as contract specifications, payment requests, etc.).
6. Standard Numbering System
Utilizing a standardized numbering system, like the Construction Specification Institute (CSI) Master Format Division, can be advantageous but is not obligatory. A well-prepared study aligns asset numbering with the contract bidding documents and payment requests. This systematic approach aids in property classification for depreciation calculations and streamlines the examination process by the Service.
7. Legal Analysis
A quality study includes a comprehensive legal analysis with pertinent citations to bolster its § 1245 property classifications. Although the treatment of certain items might be straightforward due to consistent judicial rulings, there are numerous cases where court decisions can seem conflicting or where the Service has not agreed. These apparent discrepancies typically highlight the factual complexities involved in accurately classifying property.
8. Unit Costs and Engineering Take-Offs
After identifying and categorizing property items or assets into classes such as building and personal property, it is essential to determine their individual costs. To ascertain the cost for each unit or property class within a project or component system, a detailed breakdown of total project costs or component system costs is typically required. This process is referred to as engineering "take-offs."
Cost estimates can significantly fluctuate based on the estimation guide used and whether the construction is categorized as "high" or "low" quality.
In a quality study, cost estimates are always reconciled to an acquisition price, a total project cost, or to a component system cost to ensure the accuracy of an allocation.
9. Organized Asset Listings
Typically, a study lists assets by recovery period (e.g., land, land improvements, furniture and fixtures, electrical systems, plumbing systems, equipment).
A quality study’s asset listings tie to a taxpayer's fixed asset ledger, which also facilitates the Service’s review.
10. Cost Reconciliation
It is important that the same estimating technique be used on all of the items that reconcile to a purchase price, a project cost, or to a particular component cost. If different methods or cost guides are used on different property items (e.g., one method for tangible personal property and a different method for the building), cost distortions arise.
A quality study always reconciles total allocated costs to total actual costs in order to ensure the accuracy of its allocations.
11. Treatment of Indirect Costs
A quality study outlines all costs linked to a specific project, encompassing both direct and indirect expenses, and provides an explanation for the handling of any indirect costs. Direct costs pertain to the labor and materials required for particular items or assets. Indirect costs, also known as "allocables," are non-tangible expenses associated with the construction of a facility. These indirect costs must be proportionately allocated to the basis of the specific assets they pertain to.
12. Identification of § 1245 Property
The report specifically highlights assets classified under § 1245 (e.g., personal property), which benefit from accelerated depreciation.
13. Consideration of Related Issues
The study addresses additional relevant aspects, including accounting methods, I.R.C. § 263A, and any necessary sampling techniques.
Conclusion
A quality cost segregation study ensures accurate asset classification, cost substantiation, and legal compliance. By following these 13 principal elements, property owners can confidently maximize their tax benefits while minimizing audit risks.
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