Cost segregation in estate planning

Historic_home_in_Poplar_Lawn_Historic_DistrictOne 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 fair market value 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-segregation study is implemented, the value of accelerating deductions is negated.

Considering a cost-segregation study as an estate planning tax strategy creates a use-it-or-lose-it tax 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.

View the full story from The Tax Adviser.