Cost Segregation and Estate Planning

When property is inherited at death, the heir receives a stepped-up basis to the fair market value of the property as of the date of death. This step-up eliminates any accumulated depreciation and capital appreciation, providing a fresh basis for the heir.

For example, if you purchased a property for $5 million and claimed $2 million in depreciation, your adjusted basis would be $3 million. If the property is worth $10 million at your death, your heir receives a stepped-up basis of $10 million, eliminating the $2 million of accumulated depreciation and the $5 million of appreciation.

This step-up is one of the most powerful estate planning tools in the tax code because it eliminates all deferred tax liability on appreciation and depreciation recapture. For cost segregation purposes, the step-up allows heirs to perform a new cost segregation study on the higher basis.

Performing cost segregation during your lifetime allows you to accelerate depreciation deductions, which reduces taxable income and improves after-tax cash flow. The depreciation deductions are valuable because they offset current income without requiring any cash outlay.

If you plan to hold the property until death and pass it to heirs, the accumulated depreciation is eliminated by the step-up in basis. This means you receive the benefit of the depreciation deductions during your lifetime without any long-term tax cost.

Understanding how entity structure affects tax planning is critical when evaluating whether to perform cost segregation on property you intend to leave to heirs.

When heirs inherit property, they receive a stepped-up basis to fair market value. This creates a new opportunity to perform cost segregation on the stepped-up basis, which can provide significant depreciation deductions for the heirs.

For example, if a property is inherited with a stepped-up basis of $10 million, the heirs can perform a cost segregation study to reclassify components and accelerate depreciation on the full $10 million basis. This can generate substantial deductions in the early years of ownership.

Step up basis cost segregation is particularly valuable for properties that have appreciated significantly because the heirs get to depreciate the appreciated value without ever recognizing the appreciation as taxable income.

The optimal strategy for estate planning cost segregation is to perform cost segregation during your lifetime to reduce taxable income and improve cash flow. At death, the property receives a step-up in basis, eliminating accumulated depreciation. Heirs then perform a new cost segregation study on the stepped-up basis.

This strategy allows you to maximize depreciation deductions during your lifetime without creating a long-term tax liability. The step-up at death eliminates the recapture, and the heirs start fresh with a new basis and new depreciation schedule.

For families with significant real estate holdings, this strategy can be repeated across multiple generations, allowing each generation to benefit from accelerated depreciation without ever paying depreciation recapture tax.

Cost segregation does not affect the estate tax calculation because estate taxes are based on the fair market value of assets at death, not the tax basis. Accumulated depreciation does not reduce the value of the property for estate tax purposes.

However, by reducing taxable income during your lifetime, cost segregation can allow you to accumulate more wealth, which may indirectly increase the value of your estate. This should be considered when evaluating the overall estate planning strategy.

For estates subject to estate tax, the step-up in basis provides a powerful tax benefit because it eliminates both the income tax on appreciation and the depreciation recapture. The estate tax is paid on the value of the property, but the heirs receive the property with a new basis and no deferred income tax liability.

Property that is gifted during your lifetime does not receive a step-up in basis. The recipient takes your basis (carryover basis) and continues your depreciation schedule. This means accumulated depreciation is not eliminated, and the recipient will face depreciation recapture on a future sale.

In contrast, property that is inherited at death receives a step-up in basis to fair market value, eliminating accumulated depreciation. This makes inheritance a more tax-efficient way to transfer property than gifting for properties with significant accumulated depreciation.

If you plan to transfer property to the next generation, holding the property until death is generally more tax-efficient than gifting if the property has appreciated or has accumulated depreciation from cost segregation.

Generation-skipping trusts allow property to be held for multiple generations while minimizing estate taxes. These trusts can use cost segregation to reduce taxable income during the trust's existence.

The depreciation deductions can benefit the trust or be passed through to beneficiaries depending on the trust structure and distribution policy. Cost segregation can improve the trust's cash flow and reduce the tax burden on distributed income.

For multi-generational wealth planning, generation-skipping trusts combined with cost segregation can provide significant tax benefits across multiple generations while preserving wealth within the family.

The optimal time to perform cost segregation depends on your income profile, your estate planning timeline, and the expected holding period. If you expect to hold the property until death, performing cost segregation early maximizes the benefit because you receive more years of accelerated deductions.

If you are considering selling or transferring the property within a few years, you should model the net tax outcome including depreciation recapture to ensure cost segregation is beneficial.

For more on how death and cost segregation interact with wealth transfer strategies, consult with your estate planning attorney and tax advisor to coordinate the timing of cost segregation with your overall estate plan.

Cost segregation inheritance strategies work best when property is held across multiple generations. Each generation performs cost segregation to reduce taxable income during their ownership, and at death, the property receives a step-up in basis for the next generation.

This allows each generation to benefit from accelerated depreciation deductions without ever paying depreciation recapture tax. The step-up in basis at each generational transfer eliminates the accumulated depreciation and allows the next generation to perform a new cost segregation study on the appreciated value.

For families with significant real estate holdings, this strategy can preserve and grow wealth across generations while minimizing income taxes and maximizing cash flow from the properties.