A cost segregation study is a crucial step for property owners who want to accelerate depreciation and maximize tax benefits. But is it worth the time and expense?
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To accelerate depreciation through cost segregation, you’ll need to start with a cost segregation study.
But what is a cost segregation study, how do you complete a study, and what should you expect during the process?
In this post, we’re going to break down everything you need to know about cost segregation studies, from documentation requirements to upfront fees. If you own a commercial property or hold investment real estate, keep reading to find out how to accelerate depreciation and maximize tax benefits with a cost segregation study.
Table of Contents
A cost segregation study gathers information that is used to maximize depreciation on commercial and investment properties. Typically, depreciation periods are as follows:
A cost segregation study gives an in-depth look at various components of the property (everything from appliances to landscaping) to determine costs that can be depreciated over a shorter period of five, seven, or 15 years. A cost segregation study is also crucial for property owners who want to recover costs more quickly in the first year with bonus depreciation.
The information obtained through a cost segregation study is then used to claim accelerated depreciation on a federal tax return. This accelerated depreciation provides greater immediate tax benefits and boosts cash flow.
A cost segregation look-back study is a way to retroactively claim deductions on prior years’ tax returns. A look-back study allows a catch-up tax deduction that equals the difference between the deduction already taken and the deduction that would have been available had a cost segregation study taken place when the asset was placed in service.
Based on IRS guidelines, adjustments can be made to depreciation for any asset placed in service from January 1, 1987. The catch-up tax deduction can be claimed by filing IRS Form 3115, Application for Change in Accounting Method, and does not require the taxpayer to file an amended tax return.
Many real estate owners can benefit from a cost segregation study. Individuals, corporations, partnerships, and trusts with qualifying properties may perform a cost segregation study to accelerate depreciation and boost cash flow. If you meet one of the following conditions, a cost segregation study may offer tax benefits to you.
One important thing to note is that you can not receive tax benefits from cost segregation on your primary residential residence. However, cost segregation can be used for residential investment properties.
If you’re still on the fence about whether a cost seg study is worth it, use our cost segregation calculator to see how much your business could save with this tax strategy:
There are generally four steps to completing a cost segregation study: conducting a feasibility analysis, gathering additional information and documentation, conducting property analysis, and completing a written report.
A feasibility analysis is conducted to determine if the property is a strong candidate for cost segregation. In this initial step, the various components of the property (such as flooring, appliances, and signage) will be analyzed. Through this analysis, an accountant, law firm, or other expert will be able to determine:
In the initial stages of a cost segregation study, the following documents and information are generally required:
Additional and more specific information and documentation will be required throughout the study. These requirements vary based on whether the property is an existing building or newly constructed. Additional requirements may include (but are not limited to):
The property analysis step takes an in-depth look at the property and its components. This step will also determine the costs of operation and what costs can be depreciated over a period of five to 15 years. These components are sorted into four categories, with each category having a standard rate of depreciation.
At the end of the study, a report is compiled that may include:
Using the data from your study, you (or a CPA or tax professional) can increase your tax benefits, reduce your tax liability in the years ahead, and (in the case of a look-back study) recover taxes that were overpaid.
The IRS generally recommends that all owners who have recently acquired a property have a cost segregation study performed. This is recommended even if the prior owner had a recent study completed.
Generally, a property owner will do one cost segregation study after the property has been constructed or acquired. However, an additional study may need to be performed following expansion or major renovations to ensure that the owner is capitalizing on all available tax deductions.
Cost segregation studies don’t come cheap, and several factors influence cost, including:
On the lower end, expect to pay at least $5,000 for the study and a written report. For larger or more complex situations, a cost segregation study may cost upwards of $15,000.
The length of time it takes to complete a cost segregation study varies based on several factors, including:
In general, it should take between 30 to 60 days to complete a cost segregation study.
There are two ways to do a cost segregation study. You can do it yourself, or you can hire someone to conduct the study for you.
The IRS lists six methods traditionally used to complete a cost segregation study. This includes the detailed engineering approach, which uses actual cost records, and the “rule of thumb” approach that relies more on industry averages as opposed to actual costs.
While the IRS doesn’t require you to use any specific method, you will be required to substantiate both the classification of assets and depreciation deductions, regardless of which method is used. If estimates are used instead of actual costs, the methodology and the source of cost data must be recorded.
Taxpayers with little to no tax experience will find the hundreds of pages of IRS guidelines complex and difficult to understand. Making an error during a cost segregation study and entering wrong information on an income tax return may result in thousands of dollars lost to tax repayments, penalties, and interest. For this reason, hiring a professional is well worth the expense for most.
Another option is to hire a team of experts to complete a cost segregation study. This team may include CPAs, tax experts, contractors, appraisers, and engineers.
While hiring a team is a pretty large upfront expense, these professionals understand the complexities of cost segregation studies, have an understanding of IRS guidelines, and can help you maximize deductions while reducing the risk of errors when it’s time to file your tax return.
Property owners who want to use cost segregation as a tax-deferral strategy must complete a cost segregation study. While accelerating depreciation and frontloading deductions using this method can boost your near-term cash flow, it is a costly and time-consuming process. Taxpayers who are interested in reducing tax liability should weigh out the pros and cons of cost segregation and do their research into firms that specialize in cost segregation to maximize benefits and reduce the risk of costly errors.
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