A cost segregation report can significantly impact Schedule K-1 tax reporting by affecting depreciation deductions and taxable income. If you own real estate and conduct a cost segregation study, you should know how to identify the impact on your Schedule K-1 for that tax year.
What is a Cost Segregation Report?
A cost segregation report is a tax-planning tool that allows real estate owners to reclassify certain building components from real property to personal property. A cost segregation analysis can result in significant tax savings because, unlike real property, personal property can be depreciated over a shorter period of time.
A team of engineers and tax professionals typically conducts a cost segregation study. The engineers will identify and classify all of the building components, and the tax professionals will determine the appropriate depreciation schedule for each component.
The benefits of a cost segregation study can include:
- Increased cash flow from accelerated depreciation deductions
- Reduced federal and state income taxes
- Higher property value
- Improved return on investment
Cost segregation studies are most beneficial for properties that have a high proportion of personal property components, such as:
- Office buildings
- Retail stores
- Industrial facilities
- Hotels
- Apartments
Cost segregation reporting can be complex, so hiring qualified professionals to conduct the study is essential. Learn more about cost segregation studies by reading “FAQs and Answers About Cost Segregation Studies.”
What is a Schedule K-1?
A Schedule K-1, also known as simply a K-1, is an Internal Revenue Service (IRS) form used by partnerships, S corporations, estates, and trusts to report income, deductions, credits, and other tax items to their partners, shareholders, or beneficiaries.
For partnerships and S corporations, the K-1 reports each partner’s or shareholder’s share of the entity’s income, losses, deductions, credits, and other tax items for the tax year. The partners or shareholders use this information to file their individual income tax returns.
For estates and trusts, the K-1 reports the income, deductions, credits, and other tax items to the beneficiaries. The beneficiaries use this information to file their own individual income tax returns.
The specific information included on a K-1 will vary depending on the type of entity issuing the form. However, some of the common items included are:
- Ordinary income
- Capital gains and losses
- Dividends
- Interest income
- Rental income
- Business income or losses
- Charitable contributions
Cost Segregation Impact on K-1
A cost segregation report can impact a K-1 in several ways, primarily affecting the reported depreciation deductions and taxable income.
Depreciation Deductions
Cost segregation studies allow for the reclassification of certain building components from real property (depreciated over 27.5 or 39 years) to personal property (depreciated over 5, 7, or 15 years). Depreciation deductions are spread across multiple asset classes in a cost segregation study, resulting in larger deductions in the early years and potentially a lower tax burden. This accelerated depreciation can significantly increase depreciation deductions in the early years of ownership, reducing taxable income and lowering tax liabilities.
Taxable Income
The reclassification of building components as personal property can also impact the taxable income reported on the K-1. Shifting depreciation deductions to earlier years may reduce the overall taxable income for a partnership or S corporation, potentially benefiting partners or shareholders. Depreciation deductions resulting from a cost segregation study are seen as affecting ordinary income or loss or rental income or loss, depending on the type of property.
Learn more about cost segregation studies by reading “FAQs and Answers About Cost Segregation Studies.”
It is essential to consult with a reputable tax firm like Windes that specializes in real estate taxation to understand your specific K-1 and how cost segregation can impact your reporting and tax liability.
If you are a building owner interested in retaining cash or looking for decreased dividend payout requirements in your real estate investment trusts (REITs), Windes can help make a difference in your bottom line. Connect with us today to learn more.