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What Is a Cost Segregation Study?

Cost segregation is a tax strategy that breaks down a building asset into various components, such as:

• structural components
• personal property assets
• land improvements
• leasehold improvements

Investors can accelerate their depreciation expenses and lower their tax liability by assigning shorter recovery periods to specific components, such as electrical wiring, plumbing fixtures, or flooring. This tax strategy applies to residential and commercial properties, not personal residences.

Related article: Real Estate Tax Savings: The Power of Accelerated Depreciation

Building owners need to hire a cost segregation specialist or a cost segregation firm to take advantage of cost segregation. These professionals have expertise in engineering, construction, tax law, accounting, and IRS rulings, ensuring a detailed and quality cost segregation study.

A cost segregation study aims to identify short-life property and accelerate the depreciation of these assets, enabling investors to take advantage of the time value of money.

Do you want to lower your taxes and increase your cash flow? Schedule your cost segregation study HERE.

How Does Cost Segregation Work?

To illustrate the benefits of cost segregation, let’s take a commercial building that costs $2 million to purchase. If the building owner depreciates the property over 39 years, they can claim a depreciation expense of $51,282 annually. This is an example of straight-line depreciation.

Assuming a 35% tax rate, the tax savings from depreciation expenses would be $17,949 annually.

However, suppose the building owner orders a cost segregation study and discovers that $500,000 of the purchase price is attributed to short-life property, such as tangible personal property, land improvements, or leasehold improvements. In that case, they can assign a recovery period of five, seven, or fifteen years.

This enables the owner to claim additional depreciation deductions of:

• $100,000 per year for 5 years
• $71,429 per year for 7 years
• $33,333 per year for 15 years

Assuming the building owner depreciates the remaining $1.5 million over 39 years, they can claim a total depreciation expense of $137,179 per year.

This results in tax savings of $47,952 per year, a substantial increase from the $17,949 tax savings without cost segregation.

Additionally, the building owner can free up more cash for future investments, enabling them to take advantage of the near-term cash flow benefits of cost segregation.

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When Is the Ideal Time for a Cost Segregation Study?

The best time to order a cost segregation study is during the same year as a property’s purchase, renovation, or new construction.

This allows investors to maximize their tax savings while spending a lot of money on the building structure and project-related costs.

However, building owners can also conduct a look-back study, which allows them to claim a catch-up tax deduction in the current tax year. The look-back study enables building owners to revise their prior tax returns and claim additional depreciation deductions from previous years.

Bonus Depreciation

Bonus depreciation is an IRS-allowed deduction that allows a taxpayer to take a 100% deduction in the year the asset is placed in service.

By utilizing this, investors and business owners are allowed to depreciate items with less than a 20-year life immediately in the first year.

This applies to new and used property, qualified leasehold improvement property, qualified retail improvement property, and qualified improvement property.

As a side note, bonus depreciation is being phased out starting in January 2023.

Here’s the phase-out threshold schedule:

• 2017 to end of 2022: 100% bonus depreciation
• 2023: 80% bonus depreciation
• 2024: 60% bonus depreciation
• 2025: 40% bonus depreciation
• 2026: 20% bonus depreciation
• 2027: 0% bonus depreciation

You can read more about that HERE.

3 steps to take advantage of bonus depreciation:

#1. Purchase qualified business property

• Costs of qualified film or television productions and qualified live theatrical productions
• Qualified improvement property refers to improvements made to the interiors of commercial buildings, provided that they are made after the building is open for business.
• Property with a useful life of 20 years or less, such as equipment, vehicles, furniture, fixtures, and machinery, can qualify for bonus depreciation. This category does not include buildings or land.
• Computer software can also qualify for bonus depreciation.
• Listed property, such as vehicles that are used for both business and personal purposes, can qualify for bonus depreciation if they are used for business at least 50% of the time.

#2. Place property in service

This means you must start using the asset in your business.

#3. Claim bonus depreciation on your tax return

You can write off up to 100% of the asset’s cost on Form 4562, which gets filed along with your business tax return.

Summary

Cost segregation is a valuable tax planning tool that provides additional tax deductions to real estate investors. Using a cost segregation study can provide significant tax savings for residential and commercial real estate owners.

Bonus depreciation allows owners to accelerate depreciation expenses, resulting in shorter recovery periods and additional tax savings.

They should work with tax professionals and cost segregation specialists to conduct a quality study and take advantage of the available tax benefits.

For more information about lowering taxes using a cost segregation, check out this video:

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FAQs

What are cost segregation studies, and how can they benefit my real estate investments?

Cost segregation studies are detailed analyses conducted by cost segregation professionals to identify and reclassify real estate assets for tax purposes. By segregating construction costs and components such as electrical systems and light fixtures, these studies can accelerate depreciation schedules, leading to shorter depreciation periods for certain property elements. This acceleration can significantly reduce your taxable income in the short term, offering substantial tax benefits for owners of residential real estate, office buildings, and other property types.

Can cost segregation analysis apply to residential rental properties, including single-family homes?

Yes, cost segregation analysis can be effectively applied to various types of real estate, including residential rental properties and single-family homes. This powerful tool allows property owners to maximize their rental income by optimizing the depreciation schedule, thereby lowering their tax burden over the long term. Engaging with tax advisors or cost segregation professionals is advisable to ensure the analysis is accurately conducted and compliant with tax regulations.

What role do tax professionals play in conducting a cost segregation study for office buildings and other properties?

Tax professionals, including tax advisors and cost segregation experts, play a crucial role in conducting cost segregation studies. They possess the expertise to accurately identify which components of a property, such as electrical systems or office light fixtures, can be classified under shorter depreciation periods. Their analysis ensures that real estate assets are optimally positioned for tax advantages, helping to significantly reduce the overall tax burden and enhance the profitability of real estate investments.

Are there any risks or downsides to implementing cost segregation studies for tax purposes?

While cost segregation studies offer significant tax benefits, including reduced taxable income and potential tax credits for prior years, they also come with considerations such as the potential for depreciation recapture. This could impact the tax treatment of the sale of real estate assets. It’s essential to consult with a tax professional who can provide guidance tailored to your specific property type and investment strategy, ensuring that the benefits outweigh any potential downsides.

How do cost segregation studies impact the depreciation schedule and tax obligations for newly acquired residential properties?

Cost segregation studies impact the depreciation schedule by identifying personal property assets and land improvements within residential properties that can be depreciated over a shorter period, typically 5, 7, or 15 years, rather than the standard 27.5 or 39 years. This accelerated depreciation results in a higher upfront deduction, significantly reducing the property owner’s tax obligations in the near term. For long-term real estate assets, this strategic approach can lead to a substantial reduction in tax liability, enhancing the overall return on investment.