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Benefits and Disadvantages of Cost Segregation

  1. Increases depreciation sharply in early years of ownership
  2. Increases gain upon sale
  3. Most of additional gain is capital gains instead of ordinary income

Benefits of cost segregation far exceed the disadvantages but it is appropriate to consider all factors. Cost segregation:

1) increases depreciation in early years of ownership and
2) increases the gain on sale if the property is sold without a 1031 exchange or going into an estate. (When a fully depreciated property goes into an estate, there is a step-up in basis to the current market value. In such a case, the depreciation does not increase taxes.)

If a property is sold in a typical ownership cycle (5 to 10 years), the additional depreciation generated by cost segregation will generate taxable income, usually at the capital gains rate. (The explanation for why the recapture is at capital gains exceeds this discussion. We will be pleased to discuss the mechanics of why with you or your tax preparer.) The end result is two benefits:

1) deferment of income taxes and
2) paying primarily at the capital gains rate instead of at the ordinary income rate.

The second benefit is not well understood in the real estate and tax business. There is still a myth that cost segregation just defers income tax. The reality is it defers and reduces (ordinary income rate to capital gains rate).