Cost segregation helps you frontload depreciation on your residential or commercial properties. It is a time-value-of-money play. Therefore, when does cost segregation make sense for maximum tax benefits?
Usually, you want to do a cost segregation study on your property immediately you place it in service or acquire it. However, where renovations are planned, you must decide whether to do the study before or after the upgrades, as each path yields different tax advantages.
At Seneca Cost Segregation, we offer custom expert advice on the best path to take based on the original cost basis and the scale of expected renovations. Talk to our team today to get a savings estimate.
What Is Cost Segregation and Why It Matters
Traditionally, you depreciate the entire cost basis of a property linearly over 27.5 years (residential) or 39 years (commercial). While the main building structure will last that long, many of your property components will be short-lived.
The IRS recognizes this reality and has explicitly spelled out how long it expects various property components to last:
- Real property (the main building structure): 27.5 or 39 years
- Site improvements (e.g., landscaping, sidewalks, swimming pools, etc): 15 years
- Personal property (furniture, fixtures, and equipment): 5 years
Therefore, subjecting your entire cost basis to the same depreciation schedule isn’t optimal. The superior approach would be to separate the components and subject each to a depreciation schedule consistent with its actual useful life. The process that makes this possible is called cost segregation.
You want to do cost segregation because it helps you claim bigger deductions upfront. Being able to frontload depreciation matters for the following reasons:
- You free up cash for reinvestment, reducing dependence on expensive loans
- The reinvestments are made earlier, giving you a longer runway to compound returns
A dollar saved or invested today is worth more than a dollar tomorrow. With cost segregation, your portfolio will perform better over time because you can maximize the compounding benefits of the time value of money.
Key Changes in Tax Laws Affecting Cost Segregation Benefits
Key changes to various tax laws and procedures have made cost segregation an even more attractive tax strategy.
The first significant change allowed investors to retroactively apply the benefits of cost segregation to properties placed in service in prior years. The IRS released Rev Proc 2022-14, which updated rules for automatic changes in accounting methods and allowed investors to apply for the same using Form 3115.
The second significant change concerns bonus depreciation, a tax incentive that allows you to deduct a substantial percentage of the cost of a qualifying property in its first year.
The original Tax Cuts and Jobs Act of 2017 initially allowed for 100% bonus depreciation through 2022, phasing it out as follows:
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
Given the legislation’s success, there was strong interest in cementing its key provisions. As a result, the One Big Beautiful Bill Act made bonus depreciation permanent and restored it to 100% for properties placed in service on or after January 19, 2025.
Properties with a recovery period of 20 years or less qualify for bonus depreciation. Therefore, when you do cost segregation and identify personal property or site improvements with a recovery period of five/seven or 15 years, you can deduct up to 100% of their costs in the first year.
When Cost Segregation Makes the Most Sense
You need to do a cost segregation study to identify short-lived assets that you can subject to accelerated depreciation. It’s best to let a professional handle the study. The potential tax savings will likely significantly outweigh the cost of hiring professionals.
Nonetheless, as a savvy real estate investor, you must establish a baseline return on investment (ROI) that justifies the costs. Here are scenarios where we believe cost segregation makes the most sense:
- Depreciable basis: Cost segregation will be cost-effective if your property has a cost basis of at least $300,000 (excluding land).
- Major renovations: Given that bonus depreciation is back to 100%, major renovations, which add short-lived assets, make a property a great candidate for cost segregation.
- Tax-payer status: When you or your spouse files as a Real Estate professional (REP) or is a material participant in a short-term rental (STR), you can use accelerated depreciation to offset business or W-2 income.
The REP/STR idea is essential because doing cost segregation and taking full advantage of bonus depreciation may cause depreciation to outpace your income. You will have a paper loss.
However, real estate income is usually passive, and you can’t use the passive losses to offset other income. With the REP and STR exceptions, the IRS can consider your real estate operations as a trade or business, making it possible to use the paper losses to offset active income.
When Cost Segregation Doesn’t Make Sense
In certain situations, the potential return on investment may not justify the effort of doing cost segregation. Here are the scenarios where cost segregation may not be beneficial:
- Typically (not always) where there is a low depreciable basis of less than $300,0000
- If it’s a simple building with minimal short-lived assets, e.g., a simple warehouse
- If you plan to sell the property in the next couple of years (there’s a depreciation recapture risk)
Timing Considerations for Maximum Tax Benefits
Having established the above facts, we’re now perfectly positioned to answer the core question of this post: when does cost segregation make sense for maximum tax benefits?
To properly address the before-or-after-renovations dilemma, we must introduce a powerful concept: Partial Asset Disposition (PAD). A PAD allows you to write off the remaining depreciable basis of a building component when you remove it during a renovation. It’s a one-time deduction in the year you dispose of the asset.
How can you establish the original cost basis of these components so you can accurately assign the leftover value at the time of disposition? The only reliable way is to do cost segregation. Specifically, the cost segregation should have been done before you disposed of the assets.
Therefore, you should consider:
- Doing a study before renovations: To establish the basis of the assets you want to retire. It’s strategically advantageous when the improvements will include the replacement of highly valuable components like an HVAC system and elaborate interior finishes.
- Update the study after renovations: To accelerate the depreciation of the new components you installed.
Therefore, if the goal is to get ‘maximum tax benefits,’ you want to get both tax benefits: a PAD deduction on the assets you retire and accelerated depreciation on the new assets you install. You can reliably achieve this goal by commissioning a study before the renovations.
Also, as we mentioned earlier, you can retroactively apply the benefits of cost segregation to properties placed in service in prior years.
If you held a property for several years and are now just considering cost segregation and renovations, a study before renovations makes sense. You’ll establish the initial basis of the short-lived assets before you dispose of them and ‘catch up’ on all the depreciation you may have missed.
Tax & Compliance Considerations
Using cost segregation to maximize tax benefits can significantly speed up the rate at which you grow your portfolio. However, you must do everything correctly to ensure you don’t expose yourself to audit risk.
It’s for this reason that we recommend letting a professional do the study. A valid study must meet the standards in the IRS’s Cost Segregation Audit Technique Guide, which outlines the following expectations for a quality study:
- The cost segregation report should identify the preparer and reference their expertise, credentials, and experience.
- The study must describe the methodology employed and outline the steps taken to identify assets and allocate costs.
- The study should rely on solid documentation and minimal cost estimating.
- The study should keep a record of interviews conducted with relevant parties.
- The study should contain a thorough legal analysis, including relevant citations to support property classifications.
- The study should use common nomenclature and not ‘creative’ descriptions, which may be used to hide the true nature of an asset.
Working with Professionals
While working with a professional is recommended, cost segregation companies aren’t created equal. The IRS explicitly states that a study conducted by someone with an engineering background is more reliable than one done by someone with no engineering or construction experience.
At Seneca Cost Segregation, we use an engineering-based methodology to identify and classify building components, ensuring the study can withstand IRS scrutiny. Our engineers have performed over 10,200 studies nationwide.
Here’s what you get when you work with our experienced team:
- An audit defense guarantee so you have peace of mind
- Compliance with IRS guidelines and industry best practices
- Complete and accurate documentation to support our findings
- Tailored advice that takes your unique tax planning goals into account
- Post-study support to help you and your CPA implement the findings effectively
- A dedicated account manager so you have a single point of contact with the entire team
- Thorough analysis to identify and reclassify all short-lived assets eligible for accelerated depreciation
Moreover, you can get an upfront estimation of potential tax savings before we do the study so that you can gauge the likely ROI on your investment. Request a free proposal.
Frequently Asked Questions (FAQs)
Let’s now answer some of the common questions we get about cost segregation.
How Long Does a Cost Segregation Study Typically Take?
The duration of the study depends on the size and complexity of the property and the capacity of the firm conducting the study. That said, the typical study takes two to four weeks.
What Documents Are Needed for a Cost Segregation Study?
You’ll typically need the following documents for a cost segregation study:
- Proof of ownership
- Appraisal reports
- Engineering plans
- Architectural plans
- Invoices and receipts to support construction and renovation costs
What Is the Average Cost of a Cost Segregation Study?
The cost of a cost segregation study will depend on the size and complexity of the property. We provide a no-money-down proposal before a study is done. That said, given the potential tax savings, you’ll likely find a cost segregation study worthwhile on a property with a depreciable basis of $300,000+.
Conclusion
The combination of catch-up depreciation, partial asset disposition (PAD), and accelerated depreciation on new assets makes doing a cost segregation study before major renovations the maximum-tax-benefit strategy.
Nonetheless, this “triple-dipping” strategy should be strictly executed according to IRS guidelines. Therefore, relying on an experienced partner like Seneca Cost Segregation, who’ve already handled scenarios like yours, is essential.
Contact us today to lower your tax bill with an IRS-compliant cost segregation study.
