Cost segregation is a powerful tool that allows those who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation schedules and deferring income taxes.
A cost segregation analysis or study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations.
The primary goal of a cost segregation study is to identify all building costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for commercial properties and 27.5 years for rental residential properties).
- 5 year tax-life components: tangible personal property assets (carpeting, decorative lighting, process related systems, cabinetry, ceiling fans, etc.)
- 7 year tax-life components: all telecommunication related systems (cables, telephone, etc.)
- 15 year tax-life components: land improvements (parking lots, driveways, sidewalk, curbs, landscaping, site features like a flag pole or a pond, etc.)
Personal property assets found in a cost segregation study generally include items that are affixed to the building but do not relate to the overall operation and maintenance of the building.
Land Improvements generally include items located outside a building that are affixed to the land and do not relate to the overall operation and maintenance of a building.
Reducing tax lives results in:
- accelerated depreciation deductions
- a reduced tax liability
- increased cash flow
The depreciation deductions only count the value of the building, not the land.
Cost segregation studies can also be performed retroactively on properties acquired, remodeled, or expanded since 1987.
Instead of waiting to take depreciation over the 5, 7, or 15-year depreciation term of an asset, property owners can take the entire unrecognized depreciation deduction in the year of the cost segregation study. This allows property owners to seriously reduce their income taxes.
This technique is often referred to as a “look-back” study.
Who Performs Cost Segregation Studies?
A frequently asked question when it comes to this tax strategy is, “Can I do my own cost segregation study?”
Typically, attempting to perform one of these yourself isn’t feasible.
Usually it’s a team effort typically involving a team of tax advisors and engineers working together to decide:
- which building components should go into each category
- how much each element costs on its own
Do you want to lower your taxes and increase your cash flow? Schedule your cost segregation study HERE.
What Types Of Properties Qualify?
- Retail centers
- Medical office buildings
- Self storage
- Manufacturing facilities (heavy or light)
- Research and development centers
- Commercial real estate
Cost Segregation Study Example
Here’s a cost segregation study example, courtesy of the Warren Averett CPA group:
You buy a commercial building for $1,000,000.
Remember that the land isn’t depreciable, so you decide:
- the land is worth $200,000
- the building is worth $800,000
If you depreciate the building over 39 years, the depreciation write-off would be $20,512.82 per year. Assuming a 37% federal income tax rate, that would save you $7,569.44 in taxes.
Now, let’s say you decide to get a cost segregation study. After completing the study, your advisory team identifies the following costs:
- $100,000 of interior fixtures and finishes that can be depreciated over five years
- $100,000 of interior fixtures that can be depreciated over seven years
- $100,000 of land improvements that can be depreciated over 15 years
Based on the study, $300,000 of the $800,000 building is eligible for bonus depreciation, so 100% of the cost could be written off in 2022. Assuming a 37% tax rate, that would result in tax savings of $108,153 over depreciating the building with no cost segregation (($312,820.51 – $20,512.82) x 37%).
However, even if you didn’t take advantage of bonus depreciation, those items could be depreciated over a shorter recovery period using an accelerated depreciation method.
As a result, your estimated first-year depreciation write-off would be:
- Building ($500,000 / 39 years): $12,820.51
- 5-year property ($100,000 / 5 years): $20,000
- 7-year property ($100,000 / 7 years): $14,285.71
- 15-year property ($100,000 / 15 years): $5,000
Total first-year depreciation expense: $52,106.23
So even if you didn’t take advantage of bonus depreciation, the first-year depreciation write-off would result in a tax savings of $11,689.56 over depreciating the building over 39 years with no cost segregation (($52,106.23 – $20,512.82) x 37%).
Benefits Of a Cost Segregation Study
A cost segregation study can reduce tax liability and increase cash flow in the early years of owning a rental property.
It gives you the ability to defer taxes and the opportunity to reclaim past depreciation deductions.
Thanks to the Tax Cuts and Jobs Act passed in 2017, used personal property placed into service after September 27, 2017 is eligible for 100% bonus depreciation. That means real estate investors can deduct 100% of 5, 7, and 15 year property all in the first year, which this tax strategy makes cost segregation so powerful.