If you’ve heard of cost segregation, then you might possibly have caught wind of the most powerful tax loopholes available to investors. The next question that might be percolating at the top of your mind is: “Should I hire a company to do a cross-segregation study, or should I try to do it myself, DIY it.” If you are considering either option, here is what you need to know.
What is DIY cost segregation?
DIY cost segregation is the practice of attempting to perform a cost segregation study on your own without the help of tax professionals, engineers, or appraisers. In other words, a do-it-yourself approach to taking on a quite complex tax deduction available in the US tax code. A cost segregation study is a tax-saving strategy that real estate investors, including those with just one property, can use to significantly increase cash flow and reduce their taxable income by accelerating depreciation.
Instead of the standard “straight line” depreciation method, which spreads deductions evenly over 27.5 or 39 years, a cost segregation study breaks down a property into its components, allowing certain parts to be depreciated faster, such as 5, 10, and 15 years. A DIY cost segregation study is a cheaper option up front but could result in unintended consequences down the line, such as not being able to comply with IRS audits and misclassifications.
How a cost segregation study can save you on taxes
A cost segregation study can lead to substantial tax savings, especially in the early years of ownership. While this approach, in most people’s minds, is associated with large developers or construction companies, it’s accessible to any property owner and can be particularly beneficial for single-family homeowners, short-term rental operators, developers, and owners of multifamily or commercial buildings. The cherry on top is bonus depreciation, which allows you to claim some or all of the depreciation on the property via cost segregation in the early years. Below is an example of a 1 million dollar property and the tax savings with cost segregation in which depreciation is accelerated vs. your typical run-of-the-mill straight-line depreciation.
How are cost segregation studies conducted?
There are two main ways to conduct a cost segregation study: the “rule of thumb” approach and the “engineered” approach.
Rule of thumb approach in cost segregation studies
The rule of thumb approach is pretty much what it sounds like. Instead of analyzing a property’s individual components and estimating the exact value of each, it uses a generic formula to estimate the value of various elements as a percentage of the overall building cost.
For example, using the rule of thumb method, you might say, “the roof is 3% of the purchase price, the foundation is 2%, the cabinets are 0.5%,” and so on. This method is essentially a simplified, spreadsheet-based calculation.
Because of its simplicity, the rule of thumb approach allows for cost segregation studies to be completed in minutes. However, there’s a major downside: the IRS explicitly warns against using this method in its audit guidelines, which means it carries significant risk in the event of an audit
Pros:
- Quick and easy: This method only requires entering some values into a spreadsheet or online calculator.
- Affordable: Companies that offer these studies, like DIY Cost Seg or KBKG, typically charge between $500 – $1,000.
Cons:
- IRS warning: The IRS discourages using this approach, which can increase the risk of an audit.
To avoid issues, rule-of-thumb studies are usually conservative, meaning they often accelerate 30-50% less depreciation compared to an engineered study, leading to lower tax savings upfront.
Engineered cost segregation studies
The engineered approach is considered the “gold standard” for cost segregation studies, as recognized by the IRS. In this method, a licensed engineer, contractor, or building specialist thoroughly analyzes your property, virtually rebuilding it from the ground up.
Using IRS-approved industry databases, they accurately estimate the value of each component, from the studs to the roof.
The final product is a detailed 20 to 40+ page report, breaking down every part of the property and explaining the reasoning behind each estimate. This level of precision not only allows for the maximum possible accelerated depreciation (and a higher return on investment), but it also significantly reduces the risk of an audit.
Pros:
- IRS-recognized: This method is considered reliable and audit-friendly by the IRS.
- Higher depreciation: It typically results in the highest possible amount of accelerated depreciation, giving you greater tax savings upfront.
- Detailed reporting: The report provides a thorough breakdown of every element in your property, making it highly defensible in the event of an audit.
Cons:
Cost: Engineered studies are more expensive and time-consuming compared to the rule of thumb approach.
Is it a good idea to do a DIY cost segregation study?
That depends on what’s important to you, as a few saved bucks upfront can have bad consequences in the long term. When you opt for a DIY approach, you take on the responsibility of accurately identifying, categorizing, and documenting these components according to IRS guidelines. This is a complex process that requires not just an understanding of the property itself but also a deep familiarity with tax laws, IRS regulations, and construction methods.
Missteps in classification or documentation can lead to serious consequences, including disallowed deductions, penalties, and increased risk of an IRS audit. Essentially, DIY cost segregation shifts the burden of expertise from trained professionals to the property owner, increasing the likelihood of errors and missed tax savings.
“In my opinion, one of the most common mistakes property owners make with DIY cost segregation is underestimating the complexity involved. It’s not just about having a good understanding of the property; it also requires a solid grasp of tax regulations and depreciation methods”. Adam Chahl, Realtor on Vancouver Homesearch
What expertise is needed in a cost segregation study?
It can’t be noted enough that when dealing with any type of loophole or exception related to the American tax code should be taken with the utmost precaution, and a willingness to dot Is and cross Ts. These T crossers and I dotters can’t just be anyone, they need to have expertise in the following:
Expertise in the complexity of IRS Guidelines
The IRS has strict guidelines that govern how cost segregation studies should be conducted. These guidelines are extensive and require in-depth knowledge of both tax law and construction methods that are not exactly so commonplace in the common everyday person. A professional cost segregation study typically involves a team of experts, including tax professionals, engineers, and appraisers, who collaborate to ensure the accuracy of the study and also understand how the IRS guidelines work.
Remember, there is no greater labyrinth than the IRS tax system, and that includes both knowledge of the fundamentals, as well as how to read the details and how to administer a submission. The IRS’s Cost Segregation Audit Techniques Guide is over 200 pages long and outlines specific elements required for a compliant study. Below are some of the tax guidelines that a cost segregation professional will know inside and out, including legal precedents.
| IRS Code Section | How it relates to cost segregation |
|---|---|
| IRC Section 168(k) | Governs bonus depreciation. Allows for accelerated depreciation in the first year for qualifying property. |
| IRC Section 167 | General depreciation rules. Outlines the fundamental rules for calculating depreciation on assets. |
| IRC Section 1245 | Reclassification of assets from real to personal property. Shortens depreciation lives, accelerating tax deductions for certain components of a property. |
| IRC Section 1250 | Depreciation recapture rules for real property. Involves longer depreciation periods, typically for buildings, affecting how depreciation is calculated. |
Expertise in classifying assets
One of the most significant risks associated with DIY cost segregation is the potential for costly mistakes that you will regret later on. Misclassifying assets, failing to provide proper documentation, or overlooking key components can lead to disallowed deductions, penalties, and even IRS audits.
Common misclassifications
Sidewalks
Sidewalks can be classified as 15-year property under MACRS when considered land improvements, allowing for faster depreciation. Misclassifying sidewalks as part of the building structure in a DIY study could lead to significant lost depreciation, potentially reducing deductions by $30,000 over 15 years for a $50,000 investment.
Electrical systems
Electrical systems that serve specific equipment or tenant areas can be classified as 5- or 7-year property, offering accelerated depreciation. DIY approaches often mistakenly lump these systems with the building’s general infrastructure, which can result in up to $75,000 in missed depreciation over five years for a $100,000 specialized system.
Plumbing systems
Specialized plumbing for tenant-specific or removable fixtures can be depreciated over 5 or 7 years. Misclassification in a DIY study may result in these systems being treated as 27.5- or 39-year property, potentially missing out on $50,000 in depreciation deductions over five years for a $75,000 investment.
Expertise in administrative issues
When conducting a DIY cost segregation study, administrative tasks play an important role in ensuring compliance with IRS guidelines. Failing to properly manage these administrative tasks can lead to significant issues, such as incorrect filings and increased audit risk.
Proper documentation and filing
One of the most common administrative pitfalls in DIY cost segregation is the mishandling of documentation. Professionals in this field understand the importance of precise record-keeping and proper filing practices. For instance, all components of the property must be thoroughly documented, with corresponding photographs, receipts, and detailed descriptions. A DIY approach often lacks this meticulous attention to detail, resulting in incomplete or incorrectly submitted paperwork. This can lead to disallowed deductions or penalties during an IRS audit.
Accurate photographic evidence
Photographs are an essential part of the cost segregation study, serving as visual evidence to support the classification of property components. However, DIYers may fail to take adequate or properly categorized photos, or they might not label them correctly, leading to confusion and potential misclassification of assets. Professionals will make darn sure that every image is clearly labeled and directly linked to the appropriate documentation, which is super important for substantiating claims during an audit.
Misfiling and incomplete records
Another administrative issue that DIYers frequently encounter is the misfiling of important documents. They are filling out the wrong names, wrong classifications, and wrong dates. Professionals are trained to organize and store documents systematically, ensuring that every piece of information is readily accessible if needed. On the flip side, DIYers might misplace or lose important records, making it difficult to prove compliance with IRS regulations. This can lead to delays, increased scrutiny, and, ultimately, higher costs due to penalties or missed deductions.
Be wary of DIY when dealing with anything real estate-related, according to Alex Capozollo from Brotherly Love Real Estate, a real estate investor in both Philadelphia and San Diego
The true costs of DIY cost segregation
Upfront costs vs. long-term savings
DIY cost segregation may initially appear as a budget-friendly option, especially since it allows property owners to avoid paying professional fees that typically range from $5,000 to $15,000, depending on the complexity of the property. That being said, these apparent upfront savings can quickly dissipate and sometimes vanish into thin air when weighing the potential penalties, time investment, and increased risk of errors associated with a DIY approach.
Potential Penalties and Risks
The IRS takes cost segregation studies seriously, just like they take everything seriously meaning errors in these studies can lead to significant penalties. These penalties can arise from various factors, such as incorrect classifications, inadequate documentation, or failure to follow IRS guidelines. Here’s a breakdown of potential penalties and risks:
Accuracy-related penalties
If the IRS determines that the DIY cost segregation study was incorrect and led to an underpayment of taxes, you may face an accuracy-related penalty of 20% on the underpaid tax amount.
Cost: If your misclassification leads to $50,000 in underpaid taxes, the penalty could be $10,000.
Interest on underpaid taxes
In addition to penalties, the IRS will charge interest on the underpaid taxes, which accrues from the original due date of the tax return until the date the taxes are paid in full.
Cost : For $50,000 in underpaid taxes, at an interest rate of 5% per year, the interest could add up to $2,500 per year.
Audit risk
DIY cost segregation increases the likelihood of failing an IRS audit. Audits are not only stressful and time-consuming but can also result in additional penalties and interest if discrepancies are found.
Cost An audit can take anywhere from 30 to 100 hours of your time, and if you need to hire a tax professional to represent you, fees can range from $200 to $500 per hour, potentially adding $6,000 to $50,000 in costs.
DIY cost segregation vs. professional cost segregation
| Method | Upfront Cost | Potential Penalties & Interest | Time Investment | Audit Risk | Net Cost (Worst Case) |
|---|---|---|---|---|---|
| DIY Cost Segregation | $0 – $500 | $10,000 – $15,000 | High (30-100 hours) | High | $16,500 – $65,500 |
| Professional Service | $5,000 – $15,000 | None (Assuming Firm Follows IRS Guidelines | Low (10-20 hours) | Low | $5,000 – $15,000 |
Although a DIY cost segregation study can indeed save you money upfront, the downsides are pretty severe. It’s best to have someone who knows what they are doing to save you a world of hurt down the road.
FAQ
What types of properties benefit most from a cost segregation study?
Cost segregation studies can benefit a wide range of property types, including commercial buildings, multifamily complexes, retail spaces, office buildings, and single-family rental properties. Properties with significant non-structural components or specialized fixtures, such as restaurants, manufacturing facilities, and medical offices, are particularly well-suited for cost segregation due to the greater potential for accelerated depreciation.
How long does a professional cost segregation study take to complete?
The time required to complete a professional cost segregation study varies depending on the complexity of the property and the availability of necessary documentation. Typically, it takes about six to eight weeks for straightforward properties. More complex properties, or those with incomplete documentation, may require additional time, sometimes extending to three months.
Can a cost segregation study be performed on properties purchased in previous years?
Yes, a cost segregation study can be performed on properties that were purchased in previous years. Property owners have the option to “catch up” on missed depreciation deductions through a change in accounting method, usually without the need to amend previous tax returns. This allows investors to take advantage of accelerated depreciation, even if the property was acquired several years ago.
