Appraisers cut costs to save federal taxes on small property depreciation

Tax savings through cost segregation is no longer out of reach for small and midsize property investors. With the appraiser’s experience, analysis fees are typically one-third to one-half lower than those charged by traditional preparers.

Several years ago, a final court case ruled that tangible personal property included in an acquisition or in overhead costs must be depreciated as personal property for asset recovery, using old Investment Tax Credit principles to classify personal property.

This meant that owners of improved properties could distinguish between real property and personal property to depreciate component costs over varying useful lives. Basically, instead of depreciating an entire commercial property for 39 years, or a residential property (single-family or multi-family rentals) for 27.5 years, certain components are correctly identified as depreciable in much less time. For some 135 items, useful life periods can be 5, 7, or 15 years. This is known as cost segregation.

The result of increasing depreciation is less taxable income (which would have been taxed at 35%) and more income taxed at the capital gains rate (15%) when the property is sold. In addition, it works for any type of improved property.

Until recently, mainly large accounting or engineering firms implemented cost segregation studies, addressing large and new-build properties and sometimes outsourcing the analysis.

The prices for those analytical reports, typically in the $10,000 to $40,000 range, were out of reach for small property owners, especially those with less-than-new assets. Unfortunately, previous providers of cost segregation services have overlooked homeowners who represent the largest segment of real estate investors in the country.

Now, a revolutionary paradigm shift is opening the door to very significant savings for small property owners. Much of the change is based on introducing the efficiencies of highly informed real estate appraisers who often apply industry-accepted cost estimating techniques before determining the remaining useful life of assets. By not “over-engineering” the staff or production process, professional fees are lower. However, the results can often match or exceed those of much more expensive reports. This approach has been successfully tested in the field by IRS auditors.

Changes that appraisers are making to cost segregation analysis and reporting address: 1) the size of the property being analyzed, 2) the age of the property, and 3) affordability. O’Connor & Associates, a national real estate services company, is leveraging such techniques to effect these beneficial changes:

1. Property owners with an improvement base as low as $500,000 may benefit from cost segregation. This compares to limited properties worth $5 to $10 million and more that previously benefited.

2. Existing properties built or purchased after 1986 offer significant savings in the first year of cost segregation, even without submitting original cost documents. The IRS perfectly allows you to capture unsegregated depreciation from prior years. This compares to companies that previously applied the methodology to new construction only.

3. Fees are no longer prohibitive. To prepare an analysis and report for many small properties, the prices are low enough to generate at least 3 times the cost of the report in the first year. This compares to traditional rates that range from $10,000 to $20,000 and up for properties of comparable size.

It is advisable to keep the CPA or homeowner’s tax preparer informed throughout the process. For older properties, the CPA may need to complete a Form 3115 to submit with the tax return so the owner can save on items that were not previously depreciated, without filing an amended return.
Income generating properties with a value as low as $500,000 can achieve a 3:1 payback ratio of tax savings on the modest price of a cost segregation report. If owned for 3 years or more, the typical payback ratio is 10:1.