If you own income-producing real estate, such as rental properties, office buildings, or newly renovated commercial spaces, cost segregation studies can accelerate your return on investment and potentially enhance your financial performance.
In this article, we’ll explore cost segregation as a tax-saving strategy and how it can help you make the most of your real estate portfolio.
What is a cost segregation study?
A cost segregation study is a federal income tax tool that can boost short-term cash flow by accelerating depreciation deductions.
Typically, residential buildings are depreciated over 27.5 years, while commercial buildings are depreciated over 39 years. However, these properties are comprised of multiple components, including the building structure, internal systems like HVAC and plumbing, and exterior features such as parking lots. The IRS allows different depreciation schedules for different components of a property. For instance, certain parts, like fixtures and landscaping, can be depreciated over much shorter periods of 5, 7, or 15 years.
By identifying and reclassifying these subcomponents, property owners can accelerate depreciation and often write off a larger portion of the building’s purchase price within the early years of ownership. This enables you to realize tax benefits sooner, enhancing your cash flow.
How it works
A cost segregation study identifies four components of real estate: personal property, land improvements, buildings, and land. Each category is assigned a different depreciation schedule based on its characteristics.
Personal property: these assets have the shortest depreciation schedules, typically 5 or 7 years. This category typically includes things like carpeting, furniture, and light fixtures.
Land improvements: these have slightly longer depreciation schedules, typically 15 years. Examples include sidewalks, fences, and freestanding enclosures.
Structures and buildings: the core building structure falls under a 39-year depreciation schedule for commercial properties or 27.5 years for residential rental properties. This category includes the main structural elements, such as walls and foundational systems.
Land: unlike other components, land itself is not a depreciable asset. It is excluded from depreciation calculations, but its cost is separated from the depreciable components during the study.
Example analysis: depreciation schedules for a mixed-use property
Let’s say you recently purchased a three-story mixed-use building in a city with professional offices on the first floor and apartments on the upper floors. The purchase price was $5 million.
You hire a team of engineers and tax experts to perform a thorough on-site inspection of the property. They assess architectural drawings, mechanical and electrical plans, and other documentation to identify qualifying assets. From there, they categorize the different types of assets into appropriate depreciation schedules.
Depreciation schedule | Percentage of total depreciable basis | Assets include |
5 years | 10% or $500,000 | Carpeting, appliances, window treatments, movable partitions, tenant improvements |
7 years | 5% or $250,000 | Office furniture, certain specialized equipment, non-structural interior elements |
15 years | 15% or $750,000 | Sidewalk, fence around the parking lot, asphalt paving, signage, and site lighting |
27.5 years | 40% or $2 million | Residential sections of the building, including walls, floors, and roofing |
39 years | 30% of $1.5 million | Commercial sections of the building, including the primary structure, HVAC, plumbing, and electrical systems |
Without cost segregation, you would depreciate the entire $5 million over 27.5 or 39 years, leading to smaller annual depreciation deductions and a slower return on your investment.
Compliance and documentation
The final report from your cost segregation study must include detailed descriptions of the reclassified assets, their respective costs, and the depreciation schedules. This documentation is crucial for tax purposes and helps maintain accurate financial records.
Timing and application
To maximize the tax benefits from a cost segregation study, it’s best to conduct the study soon after acquiring a property. However, if you’ve owned your property for several years, you can still benefit by conducting a look-back study.
Look-back studies allow you to claim what’s known as catch-up deductions, which are taken in a single year and reflect the difference between what you’ve depreciated and what you could have depreciated if a cost segregation study had been done earlier. It’s generally advisable to perform a look-back study within ten years.
Leveraging depreciation strategies
Cost segregation studies can be combined with other depreciation strategies, such as Section 179 and bonus depreciation, to further accelerate deductions and maximize tax savings.
Section 179 depreciation
Section 179 allows you to deduct the full cost of purchasing or leasing eligible new or used assets up to certain limits. This includes improvements to the interior of a commercial building after it's placed in service, such as roofs, HVAC systems, fire protection systems, and alarm or security systems.
The total amount a taxpayer can elect to expense under 179 is contingent upon a maximum dollar limit. For 2024, you can deduct the full cost of qualifying purchases up to $1.22 million. Note that this deduction can only be used to offset net income and cannot create a net operating loss.
Bonus depreciation
Under the Tax Cuts and Jobs Act (TCJA), 60% first-year bonus depreciation is available for qualified assets acquired and placed into service between January 1 and December 31, 2024. This applies to depreciable assets with a recovery period of 20 years or less. There is no limit to the amount of 60% bonus depreciation, and this deduction can be used to create a loss, but you must apply the same treatment to all assets of the same class.
Maximizing the benefits of a cost segregation study
To get the most out of a cost segregation study, it’s crucial to work with experienced cost segregation specialists, including engineers and tax advisors who can provide a thorough and accurate analysis. They will help you correctly identify and classify assets, comply with IRS regulations, and maximize your tax savings.
Conducting a cost segregation study soon after acquiring or constructing a property is the best way to maximize tax benefits from the start, improving your cash flow right away. This proactive approach leads to significant tax savings in the initial years of ownership, laying a solid foundation for future financial planning.
It’s also essential to periodically review and update your cost segregation studies to account for new improvements and changes in tax laws. Regular reviews ensure ongoing tax optimization, identify additional depreciation opportunities, and maintain compliance with the latest IRS guidelines.
Take the next step
If you’re considering a cost segregation study or want to learn more about look-back studies, please contact our team of expert tax advisors. We can offer personalized guidance to help you decide if this strategy is a fit for your property and financial goals.