Cost segregation studies have become a popular tax strategy for real estate investors looking to maximize their depreciation deductions and improve cash flow.
Investors can substantially enhance their initial tax deductions by identifying and reclassifying personal property assets to reduce the depreciation period for tax purposes.
However, this strategy has its drawbacks. In this article, we’ll explore some of the less-discussed disadvantages of cost segregation studies, including the implications of depreciation recapture, the complexities of 1031 exchanges, and the administrative challenges of filing Form 3115.
Depreciation Recapture Upon Sale:
One of the primary disadvantages of a cost segregation study is that it might affect the taxes when the property is sold. While cost segregation accelerates depreciation deductions, it also increases the amount subject to depreciation recapture.
Upon selling a cost-segregated property, the IRS mandates the owner to “recapture” the depreciation that was claimed beyond the straight-line depreciation method.
This recaptured depreciation is subject to taxation as ordinary income, with a maximum tax rate of 25%. This can result in a significant tax bill that can erode the benefits of accelerated depreciation, especially if the property has appreciated substantially.
The Boot Issue in 1031 Exchanges:
Real estate investors often use a 1031 exchange to defer capital gains taxes by reinvesting the proceeds from a property sale into a new property.
However, when a cost segregation study has been performed, there’s a risk of receiving “boot,” which is any form of non-like-kind property or cash acquired in the exchange.
The boot is immediately taxable, and its presence can complicate the exchange process. It can be hard to set up an utterly tax-deferred exchange if the property’s market value is much higher than its tax basis because of accelerated depreciation.
Even if investors plan to defer all gains through the 1031 exchange, they may have an unexpected tax bill.
Filing Form 3115 for Mid-Service Changes:
In a cost segregation study conducted after a property has been in service for a period of time, the taxpayer must file Form 3115, Application for Change in Accounting Method, to report the change in the depreciation method to the IRS.
This process can be complex and requires detailed knowledge of the tax code. Form 3115 requires a calculation of the Section 481(a) adjustment to account for the depreciation that would have been taken if the new method had been in place from the beginning.
This administrative burden can be daunting and may necessitate professional assistance, adding to the overall cost of the cost segregation study.
Conclusion:
Although cost segregation studies can provide substantial tax benefits, they also have drawbacks. Essential things for investors to think about are the significant tax bill that could come from recapturing depreciation, the difficulty of a 1031 exchange with boot, and the paperwork needed to file Form 3115.
It is essential to consider these cons and the possible pros and talk to a tax expert who can give you specific advice on your case.
By understanding the whole picture, investors can make informed decisions and strategically plan for the long-term financial impact of their real estate investments.