Cost segregation can be a very effective strategy for Estate Planning Attorneys.
If the grantor of a trust owns a building, the attorney can take a proactive approach by suggesting the owner of the trust performs a cost segregation study. The study will create a temporary tax deferral, which will become a permanent deduction when the owner passes away.
Cost segregation allows an owner or investor to break apart the components in a building and depreciate each one separately. This creates shorter class lives for 20-30 percent of the building components. Shorter class lives create a larger depreciation expense, which creates additional cash flow.
When real estate is inherited, the heir’s new basis in the property received is stepped up to the fair market value of the property on the date of death. It is not based on book value or based on the original basis when purchased by the decedent. Upon the passing of the grantor, generally, there will be no depreciation recapture (depreciation with a shorter class life at ordinary income).
The tax deferral, which will become a permanent tax deduction upon the passing of the decedent, can create the additional cash flow that can be used to create a gift for heirs in $15,000 increments without filing a 709 Gift Tax Form. The $15,000 increments can be given to an unlimited number of individuals at any time. The limit is that each individual can only receive up to $15,000 only once in a given calendar year. However, if the gift is given to an individual in December, another $15,000 gift can be given to that same individual in January. The gifts will reduce the decedent’s estate.
Another often overlooked opportunity is to give the additional cash flow from a cost segregation study to a college or university (without limits). The gift is to be on BEHALF of the heir or individual. It can also be given to a medical facility (without limits) on BEHALF of an heir or individual.
Let’s look at how this opportunity can be used to reduce the estate tax.
A grantor owns several apartment buildings, but the grantor is close to the end of his natural life. The owner has ten grandchildren. He completes a cost segregation study in November. He can gift $150,000 on December 1st and another $150,000 on January 1st. This reduces the estate by $300,000 within one month. The owner can also fund the education of their grandchildren ($100,000 per child) on December 15th. This reduces the estate by another $1,000,000.
This strategy reduces the estate by $1,300,000 within four weeks.
The only challenge with this approach is that assets (in our example, apartment buildings) may have to be sold to create the cash to be gifted. This can create large long-term capital gains (LTCG), which generally is not advantageous. However, a cost segregation study can create a large tax deferral. The owner can use the cash, which would otherwise have to be paid to the IRS in January (QET) as gifts instead of selling the properties.
This will reduce the estate, allow gifts to be given before the owner passes, eliminate the need to sell assets (which will eliminate the LTCG tax), AND will not be subject to depreciation recapture upon the death of the owner.
To take advantage of this strategy, a cost segregation study must be completed in advance of the filing due date of the deceased’s final income tax return. Once the deadline has passed, the opportunity will be lost.
In addition to the above benefits, the heirs can perform another cost segregation study on the inherited property and create another tax deferral.
Kevin Jerry MST
Master of Science in Taxation
Executive Vice President
Cost Segregation Services Inc.