Cost Segregation Studies for Real Estate Funds

In the current climate of shifting economics, rising interest rates, and longer-than-projected hold periods, real estate funds are turning to cost segregation studies.

A cost segregation study is an engineering-based analysis that reclassifies components of a building into shorter depreciation categories, typically five, seven, or 15 years, rather than the standard 27.5 or 39 years. The result is accelerated depreciation deductions that can produce meaningful tax benefits for limited partners (LPs), even if current deductions are suspended or reversed upon sale of the asset.

Key Takeaways

• Cost segregation studies allow real estate fund GPs to generate accelerated depreciation deductions that offset taxable income allocated to investors across multiple funds.
• Even when depreciation deductions are suspended under passive activity rules, investors can still benefit. Suspended losses become deductible when the underlying activity is disposed of.
• Rate arbitrage creates additional value: ordinary deductions reduce income taxed at up to 37%, while Qualified Improvement Property recapture is taxed at 25%, producing a spread of up to 12 percentage points.
• Personal property identified in a cost segregation study depreciates quickly in economic value, which means minimal gain is typically recaptured at ordinary rates upon sale.
• Cost segregation can offset phantom income, which is taxable income that exceeds cash available for distribution to fund investors.
• Fund GPs should work with their tax advisor to evaluate whether a cost segregation study fits their portfolio and investor base.

How Do Cost Segregation Losses Benefit Fund Investors?

Many benefits fall under the “tax loss” umbrella. The following are among the most common.

Offsetting Income Across Multiple Funds

Sponsors often have anchor investors who are in many of their numerous funds for large commitments. If a sponsor has a series of funds generating taxable income, they could use cost segregation studies for specific properties to obtain tax deductions that could offset the taxable income allocated to their anchor investors.

This process would therefore result in losses that may be deductible to the anchor investor across all of their funds. While this doesn’t directly increase the internal rate of return (IRR) within the fund or incentive distributions to the GP, it shows investors that the GP is aware of how taxes could impact their returns and is willing to work with them to minimize their personal tax burden.

If you were an LP, would you rather invest with a GP who is conscious of your tax situation or one who is indifferent to it?

Example: Using a New Fund to Offset Income Across a Portfolio

As GPs launch additional funds, each new fund is typically larger in size, which presents opportunities to use your latest fund to create tax losses that offset the income to the anchor investors across all your funds. Here is an example:

The $1,000,000 deduction from Fund 6 was generated through a cost segregation study and would provide Joe Smith with $185,000 in federal tax savings, assuming a 37% tax rate and $500,000 in other income.  

 This is free cash flow that the LP can use for other investments, further compounding the benefit of the cost segregation study. 

How Does Tax Rate Arbitrage Work?  

In addition to the up-front tax savings from the deduction in Fund 6 created by performing the cost segregation, there is also an opportunity to arbitrage tax rates. Typically, depreciation deductions reduce income subject to a 37% federal tax rate.   

Qualified Improvement Property  

For Qualified Improvement Property (QIP), if an asset is held for more than one year, the deduction would be recaptured at a 25% tax rate for federal tax purposes when the property is sold.   

Even if you break even on the property, you’ve created an arbitrage of up to 12% for your investors by generating an ordinary deduction, which reduces ordinary income taxed at a 37% rate that is later recaptured and taxed at 25%.  

Personal Property  

For personal property, the cost seg would also generate tax deductions that could save you up to 37% in tax. When these assets are sold, the gain on the sale of personal property is recaptured at ordinary rates, but the assets' economic value typically depreciates very quickly.  

This means that a minimal portion of your sales proceeds should be allocated to these assets, and a minimal portion of the gain would be recaptured at ordinary rates (37%).  

What Happens When Losses Are Suspended?  

The above rate arbitrage is true even if the losses from the cost segregation are suspended on your investors’ personal tax returns.  

When an activity is disposed of, suspended losses relating to that activity are no longer suspended and become deductible in the current year. That means that if you had $100,000 of losses from depreciation deductions that were suspended and a $100,000 capital gain from the disposition of the asset created by the depreciation deduction, you would recognize tax savings from this situation, assuming you had at least $100,000 of other ordinary income on your tax return.  

 Comparison: With Cost Segregation vs. Without  

The following tables illustrate the difference. 

• Assumes ordinary income is taxed at 37% and capital gains are taxed at 25%.  
• Tax benefit is realized if the $100,000 of depreciation deductions are suspended until the asset is sold.