An accurate cost segregation study can be a great way to maximize your real estate tax savings.
However, like most investors, you may overlook it because you aren’t familiar with it, how it works, and how it can help your overall investment strategy.
In this guide, we explore what a cost segregation study is, how it’s done, and its potential benefits. We’ll also look at a recent cost segregation study example to help put things into perspective.
As you’ll notice, it’s best to engage experts to conduct the study to ensure accuracy, credibility, and defensibility.
You can work with us at Seneca Cost Segregation for all your cost segregation needs. We’ll defend our findings if the IRS conducts an audit.
Schedule a free consultation with us today to see if your property qualifies for cost segregation.
What is a Cost Segregation Study?
A cost segregation study is a detailed analysis of a real estate property to identify and reclassify its components or assets that qualify for accelerated depreciation.
The underlying idea is to find components that can be depreciated over a shorter schedule of five, seven, or fifteen years instead of the usual 27.5 or 39 years.
Accelerating depreciation deductions can benefit real estate investors and business owners by allowing them to enjoy cost segregation tax benefits, saving them money and improving their cash flows.
Can I Do My Own Cost Segregation Study?
Technically, if you are a qualified and experienced expert in the practice, you can conduct your own cost segregation study.
In its Cost Segregation Audit Techniques Guide, the IRS lists thirteen principle elements for a quality study. The very first principle is, “Preparation by an Individual with Expertise and Experience.”
The cost segregation approaches required by the IRS are complex. You may not understand or apply them correctly if you lack the necessary expertise and experience in engineering, tax law, accounting, and construction.
Even if you have the necessary expertise and experience, it is better to hire a cost segregation service, such as Seneca Cost Segregation, to maintain optimal objectivity.
Cost Segregation Study Benefits
You can enjoy the following cost segregation benefits if the study is successful:
- Tax Savings: Cost segregation saves you money by reducing your taxable income in the first several years of owning property. Accelerating depreciation allows you to maximize depreciation deductions, which reduces your overall tax burden.
- Improved Return on Investment: Cost segregation can potentially accelerate your real estate return on investment and improve your property’s overall financial performance.
- Improves Cash Flows: Tax savings mean pocketing more money, improving your cash flow. You can reinvest the money you save into your current or new properties.
- Opportunities for Additional Tax Savings: A cost segregation study can provide data to support other tax strategies. You can try your luck with retirement loss deductions, bonus depreciation, partial disposition deductions, and energy efficiency tax deductions.
How to Do a Cost Segregation Study
You can expect the process to follow the process below:
1. Feasibility Analysis
Most cost segregation studies start with a feasibility check to determine if your property is a good candidate for cost segregation.
The analysis is usually a basic evaluation of components such as roofing and HVAC systems.
A feasibility check can also involve getting an estimate from the cost segregation company or using an online cost segregation calculator. The estimate will show if your potential tax savings exceed the cost of the study before you proceed.
2. Gathering Information
The cost segregation firm asks you to provide all the necessary information you have about the property to help determine valuations and identify components.
You can provide recent appraisals, architectural plans or blueprints, closing documents and other purchase details, and inspection reports.
3. Property Analysis
The cost segregation consultancy comprehensively analyzes your property’s components to identify and reclassify those that can depreciate over shorter lives of five, seven, or fifteen years.
4. Calculating Tax Savings
Your cost segregation firm calculates the estimated tax savings for every identified and reclassified building component.
5. Compiling the Final Report
Finally, the firm prepares a detailed report showing the estimated total amount you can save in income taxes by applying accelerated depreciation.
The report typically includes explanations and justifications for identifying and classifying the components for when you present it to the IRS. It may also include charts, pictures, and other supporting data.
Cost Segregation Study Example
Let’s now review a sample cost segregation study to see how you could save in a related scenario.
Let’s assume you need a cost segregation study for a non-residential rental property with an office, which you placed in service on June 15, 2024. The building is worth $800,000 (without considering the $200,000 worth of land, which isn’t depreciable).
1. Calculate the Standard Depreciation
If you were to depreciate the building over the standard 39 years (without cost segregation), you would get a write-off of $20,512 per year using the following formula:
Depreciation = Cost Basis ÷ Duration of the Depreciation
= $800,000 ÷ 39 Years = $20,512
Assuming the federal tax income rate is 37%, you would save roughly $7,589 ($20,512 x 37%) in taxes each year.
2. Factor In the Study Findings
Let’s assume you decide to do a cost segregation study and that your advisory firm identifies 25% of the $800,000 cost basis is eligible for accelerated depreciation.
Here’s how that might have been classified:
- Interior fixtures worth $100,000 are depreciable over five years
- Office furniture worth $100,000 is depreciable over seven years
- Land improvements worth $100,000 are depreciable over 15 years
3. Calculate Depreciation with Cost Segregation and Bonus Depreciation
With cost segregation, 60% of the identified components qualify for bonus depreciation in 2024. So, $180,000 (60% of $300,000) qualifies for bonus depreciation and is written off in 2024.
Here is how the bonus depreciation is divided amongst the different components:
- Interior fixtures – $60,000
- Office furniture – $60,000
- Land improvements – $60,000
The remaining $120,000 of accelerated depreciation will continue to flow in over the next 5, 7, and 15 years, respectively.
- $40,000 for 5 years
- $40,000 over 7 years
- $40,000 over 15 years
The remainder of the property is worth $500,000 ($800,000 – $300,000 = $500,000). This $500,000 will be depreciated over 39 years:
Depreciation over 39 years = $500,000 ÷ 39 = $12,820
Total depreciation for the property in 2024 will be:
- $12,820 written off from 39-Year property +
- $40,000 from 5-year property using 60% bonus depreciation +
- $40,000 written off from 7-year property using 60% bonus depreciation +
- $40,000 written off from 15-year property using 60% bonus depreciation +
Total depreciation with cost segregation (and bonus depreciation) in 2024 = $180,000 + $12,820 = $192,820
4. Compare the Difference in Depreciation
The tax savings will be from the difference in depreciation between the standard depreciation method and the cost segregation study.
2024 Straight Line Depreciation Amount = Yearly Depreciation x Time in Service for the Year
= $20,512 x 5.5/12 months = $9,401
Without cost segregation, the depreciation was only $9,401.
With cost segregation (which included bonus depreciation), the depreciation was $192,820 in 2024.
So, the additional depreciation due to cost segregation is:
Additional Depreciation = $192,820 – $9,401 = $183,419
5. Calculate the Tax Savings
To determine the tax savings, multiply the additional depreciation by the assumed tax rate of 37%:
Tax Savings = 183,419 x 37% = 67,865
The tax savings due to cost segregation with bonus depreciation would be:
Tax savings due to cost segregation with bonus depreciation = Tax savings with cost segregation including bonus depreciation – Tax savings with standard depreciation only = $67,865 – $9,401= $58,464
If some of the bonus depreciation was not used, the depreciation will roll over into the following year as a Net Operating Loss (NOL) which would carry forward the savings into Year 2.
From the above calculations, you would save more with cost segregation that includes bonus depreciation ($67,865) than with bonus-depreciation-free cost segregation ($9,401).
Conducting a cost segregation study with Seneca Cost Segregation is painless and simple. We guarantee accurate studies based on our Engineering team’s vast experience performing them for over twenty years.
We follow IRS guidelines to the letter using our simple three-step process, ensuring a fully compliant study that can withstand an IRS audit.
Lower your tax bill with a cost segregation study — get started with Seneca Cost Segregation today.
Common Misconceptions About Cost Segregation Studies
Whether you are familiar with cost segregation or new to the term, you may encounter the following misconceptions regarding cost segregation studies:
- Cost segregation studies are only beneficial for large, high-value properties. The reality is that they can benefit small, medium, and large investors across different industries.
- You don’t have any assets to reclassify. In reality, many building costs can be reclassified to shorter depreciation lives.
- The study will trigger an IRS audit. The truth is that only a study that’s too aggressive or done poorly would attract an audit. DIY or Rapid Reports have been known to cause issues for taxpayers.
- You won’t have support in case of an audit. In truth, most firms defend their studies if the IRS initiates an audit. At Seneca Cost Segregation, we even have a money-back guarantee for qualifying clients if an audit happens.
- My CPA alone can do it. The reality is that cost segregation blends accounting, tax law, and engineering principles, and it’s highly unlikely that a CPA would have expertise in them all.
- The study is not cost-effective. In reality, the return on investment is usually substantial since the tax savings usually diminish the cost of the study.
- Cost segregation is a tax loophole. The reality is that it’s a legitimate, IRS-approved tax strategy that has been used for decades.
Best Practices for a Successful Cost Segregation Study
A cost segregation study can be tricky to ace. Here are some considerations to guide you:
- Have it Done as Soon as Possible: Ideally, you should conduct a cost segregation study immediately after you place the property in service to maximize the benefits from day one and bring clarity to your tax planning and savings strategy. However, the IRS allows you to claim the benefits from previous years through “look-back” studies.
- Collect All Relevant Details Early: Having enough detailed documents can make identifying and reclassifying components more accurate.
- Engage Qualified Experts: Look for a cost segregation firm with expertise and experience in engineering, construction, tax law, and accounting. Ensure they are well-versed in the IRS’s guidelines to ensure credible results that can withstand potential audits.
- Review the Study as Needed: Review and update the study regularly, such as when you add other significant costs to the property. Periodic reviews and updates can help ensure the study complies with changes in tax law or new legislation affecting cost segregation.
Frequently Asked Questions (FAQs)
Here are answers to common questions about cost segregation studies:
Is It Worth It to Do a Cost Segregation Study?
A cost segregation study can definitely be worth it, depending on its cost and the potential ROI if the tax savings exceed the cost.
You can always reach out to us for a free savings and ROI estimate to determine if the study is worth it before you commit.
How Much Does a Cost Segregation Study Cost?
Different firms charge different amounts for cost segregation studies. The cost varies depending on the firm and the project’s complexity, scope, and size.
At Seneca Cost Segregation, we give you custom pricing that fits your needs and property dynamics.
How Long Does It Take to Complete a Cost Segregation Study?
The typical cost segregation study takes 2-4 weeks to complete, depending mainly on the project’s complexity and your readiness with the necessary property details.
Conclusion
You can use a cost segregation study to maximize your property tax savings, improve your cash flow, and reinvest the savings into new or previous projects.
However, you must first hire the right cost segregation experts to conduct the study and compile a comprehensive report that you can show to the IRS.
At Seneca Cost Segregation, our streamlined three-step process guarantees credible, accurate, and IRS-compliant cost segregation studies.
Reach out to our team today for a free savings estimate!
