Cost Segregation of Real Estate is an Extremely Powerful Tool in Family Wealth Transfer Planning

For families with large real estate holdings and business enterprises, planning for the maximization of transferred wealth to the next generations is a primary concern. Careful income and estate tax maneuvers prior to a generational transfer is imperative to preserving the estate value and maximizing after-tax growth. In today’s high-value real estate markets, there are a few immensely powerful planning tools heightened by the 2017 Tax Cuts and Jobs Act (“TCJA”) to lower the tax drag on multi-generational businesses.

Many challenges have appeared with the introduction of TCJA, while a multitude of beneficial provisions were developed, many will disappear, however, after the 2026 sunset date. Some of the most important favorable provisions of TCJA include the introduction of (1) 100% bonus depreciation for qualified property (2) Expanded section 179 expensing limitations to $1,000,000 and (3) Inclusion of roofs, HVAC’s, Alarms (Fire, Security, etc.) into section 179 write-off eligibility. These tools should be utilized soon, beginning in 2023, bonus depreciation will begin to decrease in value by 20% each year until 2026 (2023-80%, 2024-60% etc.).

A major tool for maximizing the benefits of TCJA is a cost segregation study performed by a tax and engineering team. Cost Segregations are a review of the building asset to identify and reclassify components that are (were) included in the building’s overall tax basis. This reclassification can effectively identify property with a useful life of less than 20 years such as specialized lighting and electrical systems, fixtures, land improvements, carpet, etc. and give rise to quicker, even immediate depreciation deductions, resulting in tax deferral or even elimination. A commercial building originally capitalized for 39 years at full cost can have 20-30% of the value identified for immediate deduction in the first year of the project or retroactively within the open statute period. For example, where a $6,000,000 purchased commercial building (net of land), this can create $2,000,000 in immediate accelerated deductions. For a taxpayer at the highest ordinary tax brackets, this could result in an immediate deferral of $740,000 in federal tax liability with a potential for additional state tax savings to reinvest or use appropriately.                                                        

Tax Deferral from Accelerated Depreciation

In years where a significant tax bill exists from growing business operations or major investment gains, the cashflow savings of a large deferral of tax can have a multiplicative effect in preserving wealth. Though no additional deductions are created over the life of the building, accelerated depreciation will frontload expenditures to free up cash needed for taxes and re-investment into the business. Cost segregation is especially critical to real property trade or businesses that may not claim bonus depreciation on qualified improvement property (QIP) because of the election out of the interest deduction limitation.

Oftentimes, the benefits of cost segregation outweigh the additional tax due to recapture when the taxpayer holds the property for greater than three to five years. For those purchasing real estate assets intending to quickly sell, rather than holding, a cost segregation may not provide the same discounted cash flow benefits. The impact of accelerated depreciation will be reversed by the creation of a larger gain and ordinary recapture on the building sale. Thus, a cost benefit analysis is always warranted.

The Potential Double-Dip for Family Wealth Planning                                                   

Where a conventional cost segregation would be a deferral of income tax, effective estate planning can create an elimination of tax entirely to benefit both the elder generation and the later-generation beneficiaries. When holding real estate is a fixture of the family’s wealth, the notorious Section 1014 ‘Step-up’ in basis upon death of the owner erases the large tax deferral that would otherwise shift to heirs. When heirs require liquidity for estate costs, growth of or new business ventures, the step-up of basis allows for the inherited property to match Fair Market Value (FMV) instead of the original basis, eliminating gain if sold. The step-up is also eligible for a subsequent segregation study to further accelerate write-offs.

Prior to the filing of the decedent’s last income tax return, to effectively ‘double dip,’ a commissioned cost segregation study should be performed. The TCJA bonus depreciation provisions will allow for deductions that will lower the decedent’s final income taxes. Fortunately, the depreciated building will be fully stepped up tax-free to FMV and available again for another cost segregation study, if held post-inheritance. Therefore, income tax is minimized from the decedent’s prior tax returns while allowing for another accelerated benefit when passed onto the heirs.

The benefits offered by cost segregation studies can allow for savings of tax and cashflow that help to further a family’s goals, offer liquidity, and preserve value. With the assistance of timely and effective Tax & Wealth Transfer planning professionals, current and future generations can also stand to greatly benefit from a creative permanent tax savings strategy.