December 16, 2024

Understanding cost segregation studies

A cost segregation study examines each property element and accelerates depreciation deductions for building components, such as flooring, windows, fencing, and sidewalks, resulting in considerably shorter tax lives for these components rather than the standard 27.5 or 39-year timeline.

Generally, for depreciation purposes, real estate falls into class lives of 39 years (commercial property) or 27.5 years (multifamily property), further subdivided into 15-year, seven-year, and five-year periods, which, in addition to a lesser recovery period, are eligible for accelerated depreciation in the first year.

Under the notion that accelerating tax deductions is advantageous, a service provider can be engaged to analyze the purchase price as well as subsequent improvements to determine if any of these are eligible for a reduced recovery period.

Benefits from cost segregation studies can be claimed when a taxpayer constructs a new building and is holding the property as a rental or when a taxpayer purchases an existing property, even if the purchase of the existing property was in a prior year. Instances where a study may be initiated include:

• Construction projects

  It is beneficial to begin a cost segregation study during the construction process as construction information and cost details will be easily obtainable for inclusion in the report. Before completing the cost segregation study, the taxpayer will need to know the final construction costs.

• Purchased properties

  A cost segregation study should be completed on a purchased property before the taxpayer files their tax return for the year the property was acquired.

• Look-back studies

  A cost segregation study can be performed on assets placed into service in a previous tax year. For look-back studies, a company must file Form 3115 to claim the catch-up of allowable depreciation.

• 1031 exchanges

  A cost segregation study is typically useful in the case of a 1031 exchange where additional basis (or excess basis) results from the exchange. The study dictates how this additional basis is deprecated rather than using a potentially less-advantageous method.

Downsides of a cost segregation study include the cost of the study exceeding the tax benefits and the timing of the outlay for the study versus the receipt of benefits. Additionally, when a taxpayer sells a real estate asset with additional depreciation benefits claimed through a cost segregation study, the asset may be subject to depreciation recapture at the taxpayer’s ordinary income rate rather than at the capital gains tax rate.

Tax benefits related to energy efficiency

IRC §45L tax credit for energy efficient homes

In regard to Internal Revenue Code (IRC) Section 45L, the Inflation Reduction Act (IRA) amplified many tax provisions to incentivize green energy projects. Before the IRA, a multifamily project was required to be three stories or less to qualify for this tax credit. The IRA removed this height requirement for tax years beginning in 2023. If projects meet the energy standards criteria of the Energy Star or Zero Energy Ready Home (ZERH), there are a range of credits available.

• In the case of single-family or manufactured homes, there is a tax credit available of $2,500 and $5,000 based on whether an Energy Star or a ZERH certification is achieved in the process.
• In the case of a multifamily development, a tax credit of $500 for Energy Star or $1,000 for ZERH per unit is available, increasing to $2,500 for Energy Star or $5,000 for ZERH if prevailing wage requirements are met.

IRC §179D energy efficient commercial buildings tax deduction

For taxpayers who constructed or modeled a property, conducting a Section 179D study may yield additional tax savings if sustainable design improvements were made.

The deduction amount will depend on the specific improvements and the square footage involved. The savings from a Section 179D study before the IRA were as high as $1.88 (adjusted for inflation) per square foot if the property’s heating, ventilation, and air conditioning (HVAC), building envelope, and lighting systems all met established efficiency standards. For tax years beginning in 2023, savings of $5.00 per square foot can be met, subject to certain prevailing wage requirements.

Citrin Cooperman’s Real Estate Industry Practice can assist in the evaluation of available tax savings and benefits from cost segregation studies and energy efficiency studies. Contact Blake Boshnack at bboshnack@citrincooperman.com or your Citrin Cooperman advisor to learn more.