Using Cost Segregation with Estate Planning

When a client dies, a critical estate planning area for tax professionals involves managing the step-up in basis on inherited assets for estate and income tax purposes. 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 fair market value on the date of death.

While most tax professionals focus on how the new stepped-up value will impact 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 original basis can be done even after a death occurs, but it must be done before filing the decedent’s final income tax return.

One of the most significant ways to reduce the federal income tax burden experienced by the estate of a recently deceased’s loved one is by conducting a cost segregation study on 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 of 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 the 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 (5, 7, or 15 years), often providing a sizeable 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 them, which results in a net present value. The number one reason a property owner would not want to undertake a cost segregation study is when they plan on selling the property within a short period (typically within 5 years of the study). After all, if accelerated deductions are recaptured soon after implementing a study, the value of accelerating deductions is negated.