Cost segregation is an effective tax strategy for property owners that allows them to accelerate depreciation on their real estate investments, ultimately reducing their tax burden. However, the process of performing a cost segregation study can be complex, and mistakes can result in missed opportunities or even IRS audits. Understanding the common pitfalls in cost segregation and knowing how to avoid them can help property owners and their CPAs maximize the benefits of this valuable tax strategy.
Here are some of the most typical mistakes made during the cost segregation process and practical solutions to avoid them.
Every property and taxpayer situation is unique, and a one-size-fits-all approach to cost segregation doesn’t work for everyone. For instance, property owners in certain industries or with specific ownership structures (e.g., partnerships or LLCs) may face different tax consequences that need to be carefully evaluated. Bonus depreciation is a key part of Cost Segregation that allows for a large upfront deduction on certain qualifying property. Since bonus depreciation laws change periodically, missing out on it can mean significant tax savings are left on the table.
Solution:
Tailor the cost segregation strategy to the specific needs of the property owner. A customized approach can help ensure that the study maximizes tax benefits while minimizing potential risks. Collaboration with our Cost Segregation experts and a tax advisor is key to ensuring that all factors are considered and the study is properly executed.
While cost segregation is an excellent tool for accelerating depreciation, it’s important to consider the long-term impact on your tax situation. Property owners might be focused on short-term savings without evaluating the future tax consequences of taking large depreciation deductions early in the property’s life.
Solution:
Understand how cost segregation will impact your tax situation over the years. Accelerating depreciation reduces taxable income now but may lead to higher taxes in the future due to the reduced basis for the property. Speak with us and your CPA about how to balance immediate tax benefits with future tax obligations, and consider the possibility of "recapturing" taxes when selling the property.
One of the key requirements for a successful cost segregation study is maintaining thorough documentation that substantiates all classifications, calculations, and depreciation schedules. Inadequate or incomplete documentation can slow down the process or trigger IRS audits, leaving property owners exposed to potential penalties and interest on underpaid taxes.
Solution:
Ensure that all keep supporting documentation well-organized and complete. This includes invoices, contracts, property drawings, construction spreadsheets and other relevant records that justify the asset classifications and cost allocations. Additionally, having a detailed and well-documented cost segregation report can be instrumental if the IRS ever questions the deductions.
One of the most significant mistakes property owners and CPAs make is attempting to conduct a cost segregation study without involving a qualified engineer or firm with experience in this niche area. While cost segregation can be done by a CPA or tax professional, it often requires the technical expertise of an engineer to properly identify and allocate costs among different asset classes, such as personal property, land improvements, and building components.
Solution:
Work with a reputable, experienced cost segregation firm that includes engineers and tax professionals. These experts can ensure the study is thorough, accurate, and compliant with IRS guidelines. This is especially crucial for larger or more complex properties where the potential tax savings are substantial.
Property owners sometimes overlook the fact that cost segregation can apply to existing properties, as well as new acquisitions or construction. A common mistake is waiting until the property is newly built or undergoing a major renovation to conduct a cost segregation study, but this can be a missed opportunity for older buildings or properties that have already been placed in service.
Solution:
Cost segregation can be performed on both new and existing properties. If you’ve owned the property for years, you can still benefit by conducting a cost segregation study though catch up depreciation. This allows the property owner to take all the benefit in the current year without having to amend returns.
Cost segregation is a powerful tax strategy, but it’s essential to avoid common pitfalls during the process. Working with qualified professionals, ensuring proper asset classification, keeping thorough documentation, and staying up-to-date with IRS guidelines are just a few steps property owners and CPAs can take to avoid costly mistakes. By taking a proactive and informed approach, property owners can fully leverage the benefits of cost segregation while minimizing potential risks and ensuring compliance with tax laws.
If you’re interested in exploring how a cost segregation study can benefit your real estate investment, contact Acena today. Let us help you unlock tax savings and drive greater financial success for your next project.
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Edited by Randy Eickhoff, CPA, Founder & Head Coach at Acena Consulting.