Discover the benefits of a cost segregation study for real estate investors. Learn how this tax strategy can accelerate depreciation deductions, increase cash flow, and reduce income taxes. Dive deep into the process, misconceptions, and real-world examples to determine if a cost segregation study is right for you.
Table of Contents:
- What is a cost segregation study?
- Is Cost Segregation worth it?
- Example of Cost Segregation
- Process of conducting a cost segregation study
- Identifying assets eligible for accelerated depreciation
- Calculating tax savings through cost segregation
- Common misconceptions about cost segregation studies
- Conclusion and next steps
What is a cost segregation study?
A cost segregation study is a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes. In simpler terms, it’s a way to reclassify assets to maximize categorization of purchase price to personal property and land improvements while minimizing allocation to real property. This can significantly reduce the amount of taxes owed in the early stages of property ownership.
Is Cost Segregation worth it?
Like many tax planning strategies, it depends on your unique situation. The value of a cost segregation study depends on several factors including the type of property, its cost, the anticipated holding period, and the tax situation of the property owner(s). For many real estate investors, the upfront cost of conducting a study can be offset by the immediate tax savings. However, for properties with minimal personal property or for owners with significant tax losses, the benefits may not outweigh the costs. Additionally, if ownership is subject to passive activity rules or owned by foreigners, or if the ultimate taxpayer is unable to use the excess tax deductions from depreciation, then the value of a cost segregation study is diminished. It’s essential to consult with a tax professional to determine if cost segregation is a good fit for your situation.
Example of Cost Segregation
Imagine a real estate investor who purchases a commercial building for $10 million. The purchase price is allocated 20% to land and 80% to the building. Without a cost segregation study, they might depreciate the building over 39 years, getting a tax deduction of $205,128 each year. With a cost segregation study, they might find that $800,000 (10%) of the building qualifies for 5-year life personal property and another $800,000 (10%) qualifies as 15-year life land improvements. This means they could get a bonus depreciation deduction of 80% of the segregated short life property in the first year of $1,280,000, in addition to the regular depreciation on the remaining $6,720,000.
Let’s walk through the numbers in a visualized example.
Process of conducting a cost segregation study
The process begins with a detailed analysis of construction costs or purchase price allocations, architectural drawings, and other relevant data. A site visit is then conducted to identify and photograph the property and its assets. The data is then used to allocate the costs to specific categories for tax purposes, and a comprehensive report is prepared to support the findings and to withstand IRS scrutiny.
Identifying assets eligible for accelerated depreciation
Assets that can be segregated include non-structural elements like removable partitions, removable carpeting, and wall tiling. Other assets like parking lots, sidewalks, curbs, roads, fences, storm sewers, landscaping, signage, lighting, security and fire protection systems, furniture, counters, appliances, and machinery (including machinery foundations) unrelated to the operation and maintenance of the building, and the portion of electrical wiring and plumbing properly allocable to machinery and equipment that is unrelated to the operation and maintenance of the building are also eligible for accelerated depreciation.
Here are some rough reclassification estimates for various types of structures:
| Type of Structure | Reclassification Estimates |
|---|---|
| Apartments | 10% – 20% |
| Hotels | 20% – 30% |
| Office Buildings | 10% – 20% |
| Retail Stores | 15% – 25% |
| Grocery Stores | 20% – 30% |
| Manufacturing Facilities | 20% – 60% |
| Restaurants | 25% – 35% |
| Warehouse | 10% – 20% |
Calculating tax savings through cost segregation
A cost segregation study primarily accelerates depreciation deductions. Property owners identify and reclassify assets to shorter lives. This increases their current-year depreciation expense. It can also reduce their current-year tax liability. Tax savings vary based on identified assets and the owner’s tax situation. Consider passive activity rules and ownership structures. Many limits exist. These limits affect how depreciation expense reduces taxable income from other sources.
Accelerated depreciation is essentially a timing difference. Investors must compare additional depreciation against non-accelerated depreciation. They should then calculate its net present value. Selling the property will recapture this depreciation. This means the gain on sale might be higher than without accelerated depreciation.
Common misconceptions about cost segregation studies
Many owners think cost segregation studies always benefit them. Accelerated depreciation works well when owners realize a current tax benefit. Consulting a knowledgeable tax professional is crucial. They should understand real estate and the owner’s tax situation. Beware of those who promote cost seg study benefits without understanding the owner’s tax position.
Some owners worry about audit risks. But professionals base cost segregation studies on IRS guidelines. These studies can pass IRS scrutiny. The benefits usually surpass the perceived risks or costs.
Conclusion and next steps
Maximizing tax savings is a top priority for businesses and property owners. A cost segregation study offers a valuable strategy to uncover hidden benefits and reduce tax liability. By understanding the process and benefits, and by consulting with professionals, property owners can make an informed decision about whether a cost segregation study is right for them. Contact us today to learn about how we work with Real Estate clients to optimize their tax positions.
