THIS ARTICLE IS NOT MEANT TO SUGGEST THAT THERE IS ANYTHING WRONG WITH USING A COST SEGREGATION STUDY REPORT IN CALCULATING DEPRECIATION DEDUCTION BUT RATHER TO OFFER A COST EFFECTIVE AND LEGALLY SUSTAINABLE ALTERNATIVE FOR BUDGET CONSCIOUS INVESTMENT PURCHASERS.
A cost segregation study is an accounting tool most typically used to separate the component parts of a real estate purchase into different categories for purposes of calculating the depreciation deduction on the owner’s tax return. The report generated as a result of the study is used by the tax preparer in setting up the depreciation expense schedule for those assets.
We always mention that a cost segregation study does not save the owner any taxes, and does not increase the depreciation expense deduction. Rather, it may move the tax savings and depreciation expense deduction to an earlier year.
This post on how to avoid a cost segregation study is not meant to imply that there is anything wrong with this technique. It is just that the goal of a financial adviser or controller like me is often to help reduce overhead expenses. Cost segregation study reports are often expensive. Less expensive or DIY cost segregation reports tend to be less effective for their intended purpose. In it’s audit guide for cost segregation studies, the Internal Revenue Service warns that “The lack of consistency in cost segregation studies and the absence of bright-line tests for distinguishing property contribute to the difficulties of this issue”. As a result, the reliable cost segregation studies tend to be priced in the thousands. This overhead cost directly reduced the financial benefit that might be obtained by accelerating the depreciation expense deduction.
However, one simple and effective method of avoiding the need for a cost segregation study is to do this work ahead of the sale, and include the details in the sales agreement itself. There is no inherent reason why a purchase agreement cannot contain a listing of all items in the purchase along with the information contained in a cost segregation study report. The only difference would be the source of the report.
As an oversimplified example:
A proposed sale that started as: “house with all appliances and furnishings” $1,000,000″ might be renegotiated and written as “land $200,000, building $400,000, solar electric system installed by ABC Corp. with an invoice of $4,234.56 on 2/4/2021, photo and invoice attached – $20,000, Weber barbecue grill model 123 purchased on 4/5/2023 from Ace Hardware for $723, photo and sales receipt attached – $500, 12’x8′ wooden storage shed purchased on 7/6/22 from Lowes for $3,345.78, photo and invoice attached – $1,000, etc”.
In a real case you would presumably start with a cost segregation study report as a template and fill in the purchase details in advance of the purchase and include this in the actual purchase transaction documents.
Assuming the purchase agreement is reasonable in reflection the actual items purchased and their purchase price, then these may be used in place of a cost segregation study when the tax preparer as the accounting basis for the depreciation expense schedule for the tax return.
While no tax accounting strategy is 100% fool proof, or “audit proof”, this approach, when used reasonably, creates the same benefits as a cost segregation study without the need for obtaining an outside cost segregation report.