If you want to keep more money in your pocket when it comes to taxes AND invest in property and/or your business faster, you’ve come to the right place.
A cost segregation study is a powerful tax strategy for property owners to maximize savings and improve cash flow on real estate investments. By accelerating depreciation and deferring taxes, a cost segregation study allows investors to take advantage of sizable tax deductions in the early years of a property’s ownership.
Cost Segregation is fully compliant with IRS regulations and has been upheld in tax court rulings as a legal form of tax planning. The IRS recognized Cost Segregation in 1973 with the Revenue Ruling of 73-410.
Conducting a cost segregation study involves a detailed engineering analysis by a qualified specialist, resulting in a high level of tax deductions over a much shorter timeframe than traditional straight-line depreciation.
It provides substantial tax deferral benefits in initial property acquisition and future capital projects.
What is Cost Segregation?
Without doing a study, properties depreciate in a straight-line (the same amount every year) for 27.5 years (residential) or 39 years (commercial)…but why should you depreciate things like carpeting or fencing over decades if their useful life is much shorter?
This is the premise behind Cost Segregation. You are able to claim larger depreciation deductions in the earlier years of the asset’s “life” rather than taking smaller depreciation deductions over a longer time period.
Understanding the time value of money, it’s easy to see why you would want to do this.
Cost segregation provides a way to maximize depreciation deductions legally, creating substantial tax deferrals and savings for property investors. The strategic reclassification of assets through cost segregation typically yields a 4:1 to 5:1 present value tax savings.
The Tax Benefits of Cost Segregation
What is Accelerated Depreciation?
Depreciation refers to the decline in value of an asset over time. The IRS allows for the depreciation of commercial real estate investments to be deducted from taxable income, reducing the tax owed. Accelerated depreciation speeds up this depreciation schedule, allowing larger deductions in the early years of a property’s useful life.
With a standard 39-year depreciation schedule for commercial buildings, the depreciation deduction is very small in the first years. Cost segregation accelerates this by reclassifying components with shorter useful lives into 5, 7, and 15-year property classes eligible for larger upfront deductions. This enables property owners to front-load and maximize depreciation deductions in the earlier years of ownership.
The Impact on Taxes
By accelerating depreciation, cost segregation results in substantial tax deferral and savings for property owners. Lower taxable income means reduced taxes owed in the initial years of ownership. At the same time, the property continues generating positive cash flow. This improves free cash flow available for reinvestment, debt payments, or distribution to investors.
The total depreciation amount over the life of a property does not change. Cost segregation allows accelerating when those deductions can be taken to create immediate tax savings and improve cash flow. For commercial real estate investors, this accelerated tax benefit is a major value proposition for conducting a cost segregation study.
The Cash Flow Advantages of Cost Segregation
Conducting a cost segregation study not only reduces taxes, but it can also significantly improve cash flow. The tax savings generated from accelerated depreciation and deduction of certain asset classes can free up capital for reinvestment or other uses.
Cost segregation reduces taxable income for property owners, allowing investors to retain more of the cash from rental income or sales proceeds.
For example, if a cost segregation study identified $400,000 of 5-year property from a $2 million building, that would generate $80,000 of accelerated depreciation deductions per year for the first 5 years. At a 25% tax rate, that’s an extra $20,000 in annual cash flow savings that can be utilized for the following:
- Paying down debt faster and reducing interest costs – Funding capital expenditures and property improvements
- Accumulating reserves for future expenses
- Expanding your real estate portfolio sooner
- Earning greater returns through reinvestment
The ability to accelerate depreciation and shield more income from taxes in the early years can be a huge boost to cash flow. This gives property owners more flexibility in managing their assets.
This can make a major difference in having capital on hand when you need it most – in the critical first years of ownership.
What is Bonus Depreciation?
Since the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, the benefits of cost segregation have been amplified. Since 2017, building owners have been able to deduct the full value of accelerated items from a cost segregation study in one tax year, acting as an extra first-year depreciation deduction, as defined by the Internal Revenue Service (IRS).
The TCJA legislation allowed for a 100% Bonus Depreciation on all eligible acquisitions from September 27, 2017, to January 1, 2023. The rate of Bonus Depreciation decreased to 80% in 2023 and is slated to drop to 60% in 2024.
TCJA Bonus Depreciation + Cost Segregation Studies make for a lot of tax savings which we’ll see in the Case Studies section below.
Best Candidates for a Cost Segregation Study
Certain types of properties can benefit more from a cost segregation study than others. Here is an overview of the property types that make the best candidates:
Commercial Real Estate
Commercial properties like office buildings, retail centers, restaurants, hotels, casinos, self storage facilities, and medical offices are excellent candidates for cost segregation. With high costs and relatively short depreciation schedules, a cost segregation analysis can yield significant tax deferrals and cash savings. Some specific examples include:
- Office buildings: accelerated depreciation on components like electrical, plumbing, HVAC systems.
- Retail stores: shorter depreciation for flooring, cabinetry, counters.
- Restaurants: faster write-offs for kitchen equipment, furniture, decor.
Residential Rental Property
Rental properties like apartments, townhomes, single-family rentals can also benefit greatly from cost segregation. As an alternative to the 27.5 year depreciation for residential rental property, a cost segregation study can carve out components with shorter lifespans. Examples include:
- Flooring, cabinets, countertops: 5-15 years
- Landscaping, sidewalks: 15 years
- Appliances: 5 years
- Plumbing, electrical: 15 years
Industrial Property
Manufacturing facilities, warehouses, distribution centers, and other industrial properties contain many components that qualify for faster depreciation with cost segregation. Some examples include:
- Warehouse racking systems – 7 years
- Heavy manufacturing equipment – 7 years
- Electrical systems for plant – 15 years
- Fire suppression systems – 15 years
- Security equipment – 5 years
All types of commercial real estate, as well as residential rental property, can benefit from conducting a cost segregation study. The value is applicable across diverse industries and property types.
The Cost Segregation Process
Conducting a cost segregation study involves a systematic approach to identifying assets that can be reclassified for accelerated depreciation. Here is an overview of the key steps involved:
- Data Gathering – The cost segregation specialist will gather relevant documents like original building plans, depreciation schedules, invoices, contractor details, and closing docs to understand the assets involved. Good companies will work with your CPA.
- Site Inspection – The team will do a walk-through or virtual inspection (often just an iPhone is needed) of the property to identify and photograph all assets eligible for cost segregation. This helps determine useful life categories.
- Estimation & Analysis – With the gathered data, the cost segregator will assign appropriate asset classes. They will estimate FMV (fair market value) costs for each asset. Detailed engineering-based estimations are done.
- Report Preparation – Once cost-benefit analysis is conducted across assets, a detailed report is prepared recommending the optimal segregation. This will include reclassified depreciation schedules.
- Audit Support – Most reputable companies will provide audit support if required. The cost segregation report is very comprehensive and can substantiate the reclassification. The typical timeline for a cost segregation study ranges from 2-6 weeks depending on property size and availability of documents. Property owners need to be responsive with information requests in order to complete the process efficiently.
Hiring Qualified Experts
Securing the services of a qualified engineering firm is crucial for maximizing the benefits of a cost segregation study while minimizing the risk of an audit. Some key considerations when vetting providers:
- Experience: Look for firms that specialize in cost segregation and have conducted studies for at least 10 years or more. They should have an established track record with hundreds of successful studies. Newer firms may lack the proper expertise.
- Certified Engineers: Make sure the firm employs licensed, certified engineers to conduct the engineering-based cost seg study. This ensures technical accuracy.
- Industry Knowledge: The ideal firm will have extensive knowledge of tax codes, IRS regulations, and experience interfacing with IRS agents during audits. They stay up to date on the latest IRS guidance.
- Property Type Expertise: Look for a firm with broad experience across various types of real estate like retail, industrial, multifamily, office, etc. Not all firms work with all property types.
- Credentials: Leading cost segregation firms have credentials like CCSPs (Certified Cost Segregation Practitioners) on staff. This demonstrates a deeper level of training and expertise.
- Pricing: The ROI (return on investment) of a Cost Seg is high. The cost of a Cost Segregation Study will depend on the property, the team’s expertise, amount of depreciable assets vs non-depreciable assets, audit defense terms, timeline needed, and FMV of the property. You can expect to pay low-thousands to tens of thousands for a Cost Segregation Study and receive an ROI of 2500%+ in tax savings.
- Process & Methodology: Ask about their study process, from documentation to how they derive asset classifications. The level of expertise makes a big difference in both the quality of the study and the peace of mind in case of an audit. It’s worth investing in a highly experienced cost segregation partner.
Case Studies
Here are some examples of actual cost segregation studies and the benefits realized:
Industrial Warehouse Facility
- Property Details: recently constructed 400,000 square foot warehouse facility in Fort Worth, TX
- Cost Segregation Results: Identified $5.4 million of assets eligible for 5-year depreciation
- Tax Savings: $1.35 million in present value tax savings over next 10 years
- Cash Flow Impact: Increased by $270,000/year for the next 5 years
Class A Apartment Complex
- Property Details: 200-unit luxury apartment community in Austin, TX
- Cost Segregation Results: Identified $3.2 million eligible for 15-year depreciation
- Tax Savings: $480,000 in present value tax savings over next 10 years
- Cash Flow Impact: Increased by $96,000/year for the next 15 years
Medical Office Building
- Property Details: Recently renovated 20,000 square foot medical office building in Houston, TX
- Cost Segregation Results: Identified $1.1 million eligible for 7-year depreciation
- Tax Savings: $165,000 in present value tax savings over next 10 years
- Cash Flow Impact: Increased by $55,000/year for the next 7 years
Residential Rental Property
- Property Details: Fourplex LTR (long-term rental) building with 4 residential rental units in Orlando, FL
- Cost Segregation Results: Identified $120,000 eligible for 5-year depreciation
- Tax Savings: $24,000 in present value tax savings over next 10 years
- Cash Flow Impact: Increased by $4,800/year for the next 5 years
These real-world examples showcase the power of cost segregation for maximizing depreciation deductions and generating substantial tax and cash flow benefits. The studies accurately reclassified assets into shorter depreciable lives, creating significant opportunities for accelerated depreciation. The savings can then be reinvested to grow real estate investments over the long run.
FAQs
Many property owners wonder exactly how a cost segregation study works and what it entails. Here we address some of the most frequently asked questions:
What types of properties qualify for cost segregation? Cost segregation can benefit commercial real estate such as office buildings, retail stores, warehouses, multi-family apartments, condos, assisted living facilities, manufacturing plants, and more. Even residential rental properties with as few as 5 units may qualify. The key factors are the property was built or acquired after January 1, 1987, and substantial depreciable assets exist.
How long does a study take? A simple cost segregation study can be completed in 2-3 weeks. Larger properties may take 4-6 weeks. The timing depends on the size and complexity of the assets as well as responsiveness in providing documentation.
Who should use Cost Segregation? Cost Segregation is most effective for Real Estate Professionals, Real Estate Investors, married couples with one of the members being a Real Estate Professional per IRS guidelines, business owners who own real estate, or Property Owners of high-cash-flowing real estate properties.
Final Thoughts
Conducting a cost segregation study can lead to substantial benefits for property owners and real estate investors. By classifying building components into shorter depreciation schedules, owners can accelerate depreciation deductions and lower their tax liability in both the current year and over the life of the asset. The immediate increase in cash flow from tax savings gives owners more available capital to reinvest or pay down debt. In addition, the present value of future tax savings is boosted considerably. This enhances the investor’s overall return on investment.
A cost segregation study maximizes the tax longevity of a property by frontloading depreciation early when an investor needs it most. Yet the technique is available for all types of properties, from commercial real estate to residential rentals. With the help of a qualified firm, the process is straightforward.
Now is the ideal time for property owners to explore the benefits of accelerated depreciation through cost segregation. A study can lead to thousands in tax savings and improved cash flow, providing a major competitive advantage and savings for your personal or family income.
