Cost Segregation Benefits & Drawbacks
Before you invest time and money in a cost segregation study, understand the pros and cons of cost segregation to determine if this tax strategy is right for your situation.
Cost segregation can be a lucrative tax strategy for taxpayers who own commercial or investment property. There are numerous benefits of cost segregation, but it’s not without its downsides.
If you qualify for cost segregation, find out if this strategy is right for you with our breakdown of the pros and cons of cost segregation.
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Benefits Of Cost Segregation
For eligible property owners, cost segregation can increase cash flow, freeing up more funds for further investments in your business and/or properties. Here are the benefits you’ll find through cost segregation.
Reduce Your Tax Liability With Cost Segregation
Without cost segregation, your property is depreciated on a schedule of 27.5 years (residential) and 39 years (commercial). Instead of looking at the entire property as a whole, cost segregation breaks down and categorizes various building components (everything from appliances to landscaping). These components can be depreciated on an accelerated schedule of five to 15 years.
Accelerated depreciation increases your deductions, which in turn reduces your taxable income. This means you’ll have a lower tax bill (and in some cases, may even receive a tax refund).
Retroactively Claim Depreciation With Look-Back Studies
It’s recommended to perform cost segregation in the same year you built, purchased, or remodeled your property. However, if you didn’t have your cost segregation study performed in that timeframe, it’s not too late.
With a look-back study, you can retroactively accelerate depreciation on qualified components. This can lower your tax liability, and for some business owners, may even result in a tax refund from the IRS.
And the best part? You don’t even have to file an amended return. You will, however, be required to file IRS Form 3115 to change your accounting method.
Cash In On Bonus Depreciation
In addition to the accelerated depreciation you’ll claim on building components, you can also claim bonus depreciation.
The Tax Cuts and Jobs Act outlines the rules for bonus depreciation for eligible property acquired and put into service after September 27, 2017.
Through 2022, bonus depreciation allowed property owners to write off 100% of eligible property costs in the first year. However, bonus depreciation will phase out beginning on January 1, 2027, unless new legislation is passed.
For now, bonus depreciation is gradually being phased out, and the bonus depreciation schedule is as follows:
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
Taking advantage of this immediate deduction can result in huge tax savings for property owners.
See how much a cost seg study could benefit your business with our free cost segregation calculator:
Drawbacks Of Cost Segregation
While the tax benefits of cost segregation are pretty great, there are a few drawbacks to keep in mind before you dive into cost segregation.
Cost Segregation Studies Are Expensive
Cost segregation studies don’t come cheap. Fees are generally not disclosed upfront, and you will need to contact a cost segregation company (or several to compare costs) to find out how much your fee will be. In general, expect to pay anywhere from around $3,000 to $15,000+.
The good news is that most cost segregation companies offer a free feasibility analysis. During this analysis, the company will evaluate your property and tax situation to determine if this strategy is right for you. Following the analysis, fees will be disclosed so you can determine if you want to move forward with a cost segregation study.
Of course, you could perform your own cost segregation study to avoid these fees. However, cost segregation studies are complex, and it’s easy to make errors that could result in large financial penalties later down the road.
Although cost seg studies are expensive, many property owners find that cost segregation is worth it, as the tax savings incurred significantly outweigh the upfront cost.
Cost Segregation Studies Are Time-Consuming
Cost segregation studies are quite extensive and typically take 30 to 60 days to complete. If you hire a cost segregation company, a team of CPAs, engineers, and other professionals will be doing the bulk of the work.
However, you’ll still need to gather documentation and information to provide for the study — things like receipts, invoices, purchase orders, blueprints, and other documents. You may be asked to provide additional information throughout the process. Depending on how organized you are, getting the necessary paperwork together can take some time.
IRS Audit Risk
The IRS has a strict set of guidelines for cost segregation. Failing to follow these guidelines or entering incorrect calculations could result in an inaccurate return — which comes with penalties and interest.
Section 6662 of the IRC states that “substantial underpayment” of taxes is subject to a 20% penalty. In other words, if your depreciation is incorrectly calculated, you could owe the IRS a pretty hefty payment.
To avoid this, make sure that the company you hire to conduct your cost seg study is reputable and experienced. Some companies even offer audit protection to help you navigate an IRS audit.
Following the study, it’s important to fill out your tax forms correctly. It may be worth the expense to hire a CPA or tax preparer to ensure accuracy and also cash in on other business tax deductions and credits that can lower your tax liability.
Recapture Of Depreciation
Depreciation recapture is another concern when it comes to cost segregation. The IRS has rules in place for the recapture of depreciation if the property that was depreciated to offset income has been sold for a profit.
Let’s look at a quick example. Let’s say you purchase a piece of furniture for $5,000, with the cost depreciated over a period of five years. You write off $1,000 in depreciation expenses per year for this component.
Now, let’s say that you used the furniture for four years and have taken depreciation deductions of $4,000. Subtracting these deductions from the original purchase price (also known as the original cost basis) of $5,000 shows that the adjusted cost basis is now $1,000.
After four years, you sell the furniture for $2,000. After subtracting the adjusted cost basis of $1,000, you’re left with a taxable gain of $1,000. This amount will be treated as income when you file your next income tax return.
Things get even more complicated (and expensive) if you sell a depreciable item at a higher cost than the original cost basis, or if you took bonus depreciation. These taxable gains can increase taxable income, which results in a higher tax liability.
Weighing The Pros & Cons Of Cost Segregation
Before deciding whether cost segregation is a strategy that will work for your unique tax situation, make sure to weigh out the pros and cons carefully. Consider the upfront cost required for a study, as well as how cost segregation may impact your tax returns in the future.
If you opt to move forward, connect with a reputable cost segregation company. Know what to look for in a cost seg company, including a free feasibility analysis, which can give you a better idea of how cost segregation can work (or won’t work) for you.