The benefits of using cost segregation in estate planning


This article originally appeared in The Tax Adviser.

A critical estate planning area for tax professionals involves managing the step-up  in basis  on inherited assets for estate and income tax purposes after someone dies. The general rule for real estate is that when a property   is inherited, any gains built up during the decedent’s life are not recognized. The beneficiary also receives a step-up, which means the property’s tax basis is reset to its fair market value (FMV) on the date of death.

While most tax professionals focus on how the new stepped-up value will affect taxes on the decedent’s estate and the beneficiary’s income tax liability, many overlook the opportunity to manage the decedent’s original tax basis for real estate assets that are recorded on their tax depreciation schedule before death. This change to the property’s basis can be done even after a death occurs, but it must be done before filing the decedent’s final individual income tax return.

One of the most effective ways to reduce the federal  income tax burden on a recently deceased taxpayer’s estate is by conducting a cost-segregation study of the original pre-stepped-up basis of buildings the decedent held. This typically generates an immediate large accelerated depreciation deduction that can eliminate tax owed on the final federal income tax return, all while reducing the building’s pre-stepped-up tax basis.

However, since the federal income tax basis on the building is reset to FMV on the date of death, neither the decedent nor the heirs realize any offset to future deductions typically associated with cost-segregation studies. Additionally, the recapture tax whipsaw that is paid upon sale of property on the accelerated depreciation deductions does not occur in estate planning situations.

A cost-segregation study allows building owners to accelerate depreciation deductions that typically are taken over an extended period (i.e., the 27.5- or 39-year periods that apply to depreciate residential or nonresidential buildings)  into a much shorter span that applies to other types of property other than buildings (five, seven, or 15 years), often providing a sizable current-year “catch up” depreciation deduction under Sec. 481(a).

Cost-segregation studies usually don’t create extra deductions  over the life of the property. They simply  accelerate these deductions, which results in a net present value. The No. 1 reason property owners would not want to undertake a cost-segregation  study  is when they  plan on selling the property within a short period (typically within five years of the study). After all, if the accelerated taxes are recaptured soon after a cost- situation, as the accelerated depreciation deductions are never recaptured upon sale and the building’s depreciable tax basis is reset upon death. This strategy works even if the cost-segregation study is completed after death, but it must be implemented before the extended due date of the decedent’s final income tax return.

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