Cost Segregation Studies in Real Estate

Cost segregation is a powerful tax strategy that allows rental property owners, whether individuals or companies, to significantly reduce taxable income by accelerating depreciation deductions. This strategy is particularly beneficial for those looking to maximize tax savings, optimize cash flow, and reinvest in their properties. A cost segregation study, typically conducted by a qualified accountant in collaboration with a building engineer, analyzes acquisition and construction costs to identify assets that qualify for accelerated depreciation.

Advantages of Cost Segregation

Cost segregation is most effective for properties valued at $1 million or more. The process begins with establishing the cost basis, which is the original cost of the property minus land costs (as land is not depreciable). Over time, the tax basis is adjusted downward to account for depreciation due to wear, tear, and obsolescence. A cost segregation study is instrumental in determining which assets can be depreciated and for how long.

For example:

• Residential rental properties are depreciated over 27.5 years.

• Commercial properties are depreciated over 39 years.

• Certain assets such as plumbing fixtures, carpeting, sidewalks, and fences can be depreciated over a shorter time frame—five, 10, or 15 years if separately acquired during renovations.

A detailed cost segregation study relies on comprehensive documentation, including acquisition records, construction blueprints, inspections, invoices, contracts, and appraisals. Assets are categorized into different depreciation schedules—five, 10, or 15 years—along with those eligible for bonus depreciation.

Bonus Depreciation

Bonus depreciation allows for larger tax deductions in the initial years of ownership, thereby reducing taxable income and enhancing cash flow. However, strict regulations apply:

• Rental properties cannot be depreciated at 100%.

• Assets cannot be acquired through a relative or friend.

• The property cannot have been used by the taxpayer before its acquisition.

The 2017 Tax Cuts and Jobs Act enabled 100% expensing for business property acquired and placed in service after September 27, 2017, but before January 1, 2023. After 2022, this benefit decreases by 20% per year, expiring on January 1, 2027. If you purchased a rental property in 2024, you can claim 60% of bonus depreciation. Bonus depreciation applies only to assets with a useful life of 20 years or less and excludes residential properties from full eligibility.

To qualify for depreciation, a property must:

• Be owned by the taxpayer (not leased or rented from another party).

• Be used for business or investment purposes.

• Have a determinable useful life.

• Have an expected life of more than one year.

Depreciable vs. Deductible Costs

• Capital improvements that upgrade, adapt (e.g., converting a commercial building into housing), or enhance a property are depreciable.

• Operating expenses and repairs that maintain the property in its original condition are deductible in the same tax year if they are ordinary, necessary, and reasonable business costs.

Example of Cost Segregation Benefits

Consider an investor who purchases an office building for $1 million. If the land appraisal values the land at $200,000, then the depreciable portion is $800,000:

• Depreciation over 39 years: $20,512.82 per year

• At a 37% federal tax rate, this saves $7,500 per year

With a cost segregation study:

• $100,000 in interior fixtures can be depreciated over five years.

• $100,000 in land improvements can be depreciated over 15 years.

• $100,000 in additional assets can be depreciated over seven years.

• Bonus depreciation (60%) on these assets in 2024 allows for an initial deduction of $52,106.23, compared to just $7,500 without cost segregation.

The advantage of accelerating depreciation lies in the time value of money—taking deductions earlier is more valuable than spreading them over decades. The increased cash flow can be reinvested into the business, yielding greater financial benefits.

Disadvantages of Cost Segregation

While cost segregation offers substantial benefits, it comes with certain risks and costs:

IRS Audit Risk

Although cost segregation is a well-established tax strategy, improper execution can trigger an IRS audit. To mitigate this risk:

• Follow the IRS Field Audit Techniques Guide (ATG).

• Use professional services rather than attempting the study independently.

• Ensure accurate asset classification to avoid IRS penalties for valuation overstatements.

Cost of the Study

• Cost segregation studies range from $5,000 to $20,000+, making them most beneficial for larger properties.

• They are not applicable to personal property.

• To justify the cost, property owners should plan to hold onto the property for at least three to five years.

Time Commitment

A cost segregation study can take one to two months to complete, requiring detailed documentation and analysis.

Depreciation Recapture

Depreciation is a tax deferment, not an elimination. When selling a property, the IRS recaptures depreciation as taxable income. To minimize or avoid recapture taxes:

1. Conduct a 1031 Exchange – reinvest proceeds into a similar property to defer taxes.

2. Pass the property to heirs – eliminates capital gains and depreciation recapture upon inheritance.

3. Sell at a loss – offsets taxable gains from other properties.

When selling, property owners face depreciation recapture rates as high as 35% plus state taxes, and section 1250 gains taxed at 25%. Investors in high tax brackets benefit most from cost segregation studies and professional tax planning.

Conclusion

Cost segregation is a valuable tax strategy for rental property owners, offering accelerated depreciation and increased cash flow. While it requires a financial investment, careful planning, and professional execution, the benefits often outweigh the costs. Properly navigating tax laws and leveraging cost segregation can lead to substantial savings and long-term wealth accumulation.