Cost segregation is a powerful tax strategy that allows real estate investors to utilize accelerated depreciation deductions. It results in substantial tax savings, improved cash flow, and enhanced return on investment (ROI) on their real estate investments.
It’s a “secret” that savvy real estate investors have used for years to minimize tax liabilities. And the good news is? It’s not really a secret! It’s available to anyone who understands how to leverage the IRS Tax Code effectively.
What Is Cost Segregation?
Cost segregation enables real estate owners to reclassify certain components of investment properties for accelerated depreciation (5, 7, or 15 years), compared to traditional residential real estate depreciation (27.5 years) or commercial real estate depreciation (39 years) schedules.
The Benefits of Cost Segregation
Cost segregation offers the following advantages:
Tax Savings
Accelerated depreciation reduces taxable income, which is particularly beneficial in the early stages of property ownership. This is advantageous for investors looking to reinvest these savings into additional properties or improvements to existing ones.
Enhanced Cash Flow
Increased annual tax deductions improve cash flow for investors.
Improved Investment Returns
Combined tax savings and enhanced cash flow bolster overall ROI for real estate properties.
Insurance Premium Reduction
Detailed reports can lower insurance premiums by accurately assessing risks and supporting claims for building component replacements.
Properties That Benefit the Most
Commercial buildings, apartment complexes, and industrial facilities benefit most from cost segregation due to substantial components and improvements. However, even a smaller residential rental property can achieve significant tax savings.
Potential Risks and Mitigations
Consider the following risks associated with cost segregation:
Depreciation Recapture
When a property is sold, the IRS may recapture some of the accelerated depreciation. Investors should plan for this potential tax liability by consulting with tax professionals.
Complexity
The process can be complex and requires expertise. Engaging experienced professionals ensures accurate and compliant cost segregation studies, minimizing the risk of errors.
Negligence Penalty
Taking an aggressive stance in a cost segregation study can lead to a negligence penalty, amounting to 20% of the tax underpayment—even if the investor didn’t conduct the study. Working with qualified professionals is essential to avoid such penalties and ensure the integrity of tax filings.
How Do You Choose the Right Cost Segregation Firm?
Select firms with experience in similar property types, positive client testimonials, and industry certifications. Ensure their cost segregation team includes seasoned engineers and tax experts well-versed in current tax laws and regulations.
What Is a “Quality” Cost Segregation Study?
According to IRS guidelines, a quality cost segregation study should be accurate, well-documented, and prepared by individuals with expertise in construction and tax law related to property classifications for depreciation (pages 24-25 of the linked PDF).
The IRS states that a quality study should include the following items:
Asset Categorization
Properly classifying assets into categories such as land, land improvements, buildings and structures, furniture, fixtures, and equipment.
Justification for Classification
Providing clear explanations and legal citations for categorizing assets as §1245 (personal property) or §1250 (real property).
Cost Basis Verification
Confirming the cost basis of each asset and reconciling the total allocated costs with the actual total costs.
The Cost Segregation Study Process
The process begins with commissioning a cost segregation study from a financial firm that specializes in engineering, construction, tax law, and accounting.
- Conducting a feasibility analysis to determine if the property is suitable for cost segregation. This analysis reviews items such as roofing, flooring, sidewalks, driveways, interior fixtures, and electrical and plumbing fixtures.
- Performing a property analysis to examine architectural drawings, blueprints, and construction documents.
- Undertaking a site inspection at the investment property to identify components.
- Classifying assets into categories such as land, building, land improvements, and personal property.
- Producing detailed reports that outline reclassified assets and their respective depreciation schedules.
Asset Classification
The following are examples of asset classifications:
5-Year Assets
Fixtures like carpet flooring, countertops, cabinetry, breakroom sinks, specialty lighting, dedicated electrical outlets, and safety equipment.
7-Year Assets
Office furniture like desks, chairs, and cubicles.
15-Year Assets
Land improvements like drainage systems, parking lots, driveways, landscaping, protective bollards, outdoor swimming pools, and sidewalks.
Cost Segregation Analysis Example
Imagine purchasing a commercial office building for $10 million. Excluding the $2 million land value, the building’s value is $8 million.
Using the 39-year straight-line depreciation method for commercial properties, the annual depreciation expense is $205,128, saving you $75,897 annually if you are in the 37% tax rate bracket.
You decide to have a cost segregation study performed, leading to these allocations:
- $1,300,000 of land improvements depreciated over 15 years
- $600,000 of office furniture depreciated over 7 years
- $900,000 of interior fixtures depreciated over 5 years
The remaining $5,200,000 is assigned to the building’s value, depreciating over 39 years.
Based on these findings, the annual depreciation amounts are:
- Building: $5,200,000 / 39 years = $133,333
- 15-year land improvements: $1,300,000 / 15 years = $86,666
- 7-year office furniture: $600,000 / 7 years = $85,714
- 5-year interior fixtures: $900,000 / 5 years = $180,000
This achieves a total first-year depreciation of $485,713, saving you $179,713 in taxes—an increase of $103,816 over your tax savings of $75,897 using the 39-year depreciation rate.
Cost Segregation Comparison
Note: This example does not account for any potential bonus depreciation as described next.
Bonus Depreciation and the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a 100% bonus depreciation rate for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. This means investors can immediately deduct the full cost of qualifying property. For properties placed in service after January 1, 2023, the bonus depreciation rate phases down as follows:
- 80% for property put in service in 2023
- 60% for property put in service in 2024
- 40% for property put in service in 2025
- 20% for property put in service in 2026
What If Your Property Is Already in Service?
A look-back study can recapture accelerated depreciation deductions missed if a study was not completed when the property was initially constructed, purchased, or remodeled. The IRS allows you to file Form 3115 to claim the catch-up tax deduction—dating back to January 1, 1987—without amending prior returns.
Is Cost Segregation an Incentive to Use Sustainable Building Practices?
Investors who make sustainable upgrades to properties can use a cost segregation study to accelerate depreciation and save on taxes. Energy-efficient improvements like LED lighting, HVAC systems, and water-saving fixtures qualify for shorter depreciation periods, resulting in immediate tax advantages.
Does a Cost Segregation Study Impact State Income Taxes?
While the primary focus is often on federal tax savings, cost segregation can also impact state income taxes. Different states have varying state-specific rules regarding depreciation and tax deductions. A detailed cost segregation study can help investors maximize their state tax benefits as well.
What Is the Future of Cost Segregation?
The landscape of cost segregation is likely to evolve with changes in tax law and advancements in technology. Future trends may include increased automation in cost segregation studies, more refined methodologies, and expanded tax incentives for sustainable and energy-efficient building practices. Staying informed about these changes will be crucial for investors looking to continue to take full advantage of these benefits.
Maximize Your Tax Savings With Cost Segregation
Cost segregation is a powerful tax strategy for real estate investors looking to maximize tax savings, increase cash flow, and improve their ROI. By understanding the process and benefits, investors can make informed decisions that support their financial goals.
Consult with tax professionals who are expert real estate CPAs to ensure compliance and helps mitigate potential risks such as depreciation recapture and negligence penalties. This strategic approach can significantly enhance the profitability and long-term success of an investor’s real estate portfolio.
