This is a complicated but potentially very worthwhile strategies to pursue in estate in which the decedent owned valuable depreciable real estate (e.g. office buildings, shopping centers, or multiple rental homes). Thanks to Bob Keebler, CPA for the following memo:
A unique opportunity many lawyers, CPAs and trustees miss during the estate administration process is to recommend cost segregation studies. Such studies may be applied on both a going forward basis and for the open income tax years prior to an individual’s death. A cost segregation study simply allows the owner of real property to reclassify segments of what would otherwise have been treated as 27.5 and 39 year life depreciable property as 5, 7, or 15 year property.
By accelerating depreciation deductions in this manner, a taxpayer is able to increase the economic/financial value of the depreciation deduction. While many clients did not conduct cost segregation studies during their lifetime because they felt they were simply accelerating depreciation, at death all prior depreciation is “forgiven” and the client’s family receives a new stepped-up basis.
For instance, an apartment complex is placed in service during 2000 for $5,000,000 using a 27.5 year depreciable life. Through cost segregation analysis, $1,000,000 is reclassified to a five year life and $400,000 to a 15 year life. The resulting change in depreciation provides an additional $840,000 deduction in 2007.
Surprisingly enough, as an item of post-mortem planning, cost segregation studies may be commenced for the period before a person dies since amended income tax returns can be filed within a three year statute of limitations. Along the same line, a “catch-up” depreciation deduction may also be taken for any year prior to death, which in essence generates a free/incremental deduction.
An example from our client base may be helpful. David died holding a large real estate portfolio. Prior to his death he had not engaged in cost segregation studies. During the administration of his estate, we recommended that the trustee conduct a cost segregation study. The result of this study was an additional $8 million of depreciation which was available for the year of death combined with the two prior open carryback years.
Additionally, on a going forward basis, we were able to perform cost segregation studies based upon the stepped-up value of the real estate. Although more analogous to the typical cost segregation study, this also resulted in additional depreciation during the estate administration and in subsequent years. In fact, because most of the property passed to a QTIP trust for the benefit of David’s spouse, the depreciation, including the additional cost segregation depreciation, will again be “forgiven” because of the step-up in basis at the death of David’s wife.
To receive this treatment one needs to:
1) Prepare a cost segregation report;
2) File Form 3115 – Change in Accounting Method; and
3) File amended income tax returns.
1 - Interesting enough, this large of an adjustment occurred because the change in accounting method allowed “catch-up” depreciation from the inception of the project in the year 2000.
2 - Professional advisors must also understand whether the adjustment made for a depreciation “catch-up” will be a passive activity loss (PAL) or a nonpassive activity loss. For example, if the adjustment is a PAL under Code Section 469, some of the PAL can be suspended until a future year and the benefit of the cost segregation study can be very limited. A suspended PAL, that remains after death (and after the activity in the year of death), is permanently lost unless the step-up at death is less than the remaining deduction. Then the suspended PAL in excess of the step-up can be deducted on the final return. Such analysis must be made on an individual property method, unless certain Code Section 469 grouping elections have been made. Also, different Code Section 469 and step-up rules can apply to joint returns depending upon whether community property rules apply to the certain property owned at death.