What Is Cost Segregation?

What is cost segregation in real estate, and why should you consider using this tax strategy before filing your next federal income tax return?

If you’ve recently purchased, built, or remodeled an investment or commercial property, cost segregation helps you maximize depreciation, reduces your tax liability, and can help you put more money back into your pocket. Here’s what you need to know about cost segregation.

The Basics Of Cost Segregation

Cost segregation is a tax strategy that property owners can use to accelerate the depreciation of a commercial or investment property. Traditionally, properties depreciate on a schedule of 27.5 years or 39 years. Cost segregation allows for certain components of the property to be depreciated over a shorter timeline of five, seven, or 15 years. This accelerated depreciation can lower a property owner’s tax liability and increase cash flow.

Cost seg can be used after purchasing, constructing, or remodeling a qualified commercial or investment property.

What Is Depreciation?

To understand cost segregation, you must first know how depreciation works. Depreciation allows you to claim an annual tax deduction on tangible assets. Depreciation is essentially an allowance that accounts for wear and tear, deterioration, or if the asset becomes obsolete.

Most tangible property can be depreciated, with the exception of land. Intangible property, such as patents and software, may also be depreciated. IRS guidelines for depreciation further clarify conditions for property depreciation. These guidelines state that property must:

• Be owned by you
• Be used in your business or to produce income
• Have a determinable useful life
• Be expected to last for longer than one year

Commercial properties are generally depreciated over a period of 39 years, while residential investment properties (think apartment buildings or single-family rental homes) are depreciated over a period of 27.5 years.

Cost segregation allows property owners to claim depreciation on qualified components of the property on an accelerated timeline.

What Is Cost Segregation Bonus Depreciation?

Businesses that use cost segregation can use bonus depreciation to further boost their tax benefits. Bonus depreciation is an additional special allowance that businesses can claim during the first year of acquiring qualifying business property and putting it into service.

Under the Tax Cuts and Jobs Act of 2017, bonus depreciation was extended through 2026. The TCJA also increased bonus depreciation to 100% for qualifying property that was acquired and put into use after September 27, 2022, and prior to January 1, 2023.

Bonus depreciation will be gradually phased out. The bonus depreciation rates through 2026 are as follows:

In previous years, only new property qualified for bonus depreciation. However, used property now qualifies for bonus depreciation, provided IRS guidelines are met.

What Qualifies For Cost Segregation?

To qualify for cost segregation, your property must be one of the following:

• Newly purchased commercial property
• Newly constructed commercial properties
• Investment properties
• Recently renovated commercial or investment property

Personal residences do not qualify for cost segregation.

Cost segregation is used to accelerate depreciation on certain components of a qualified property. This includes but is not limited to things like:

• Appliances
• Machinery
• Lighting
• Signage
• Furniture
• Land improvements

How Does Cost Segregation Work?

As previously mentioned, the depreciation of your commercial or investment property is spread over a period of 27.5 years or 39 years. With cost segregation, certain components can be depreciated over a shorter period of time. Here’s a general overview of the depreciation schedule for each component of your property:

The accelerated depreciation that comes with cost segregation allows you to frontload your deductions, reducing your federal income tax liability and freeing up more cash to put into your business or investment properties. Combined with bonus depreciation, the benefits of cost segregation can be significant.

To determine what can be depreciated on an accelerated schedule, a cost segregation study is performed. During this study, a team of experts will identify and classify these components so you can maximize your tax benefits.

Cost Segregation Studies

In order to take advantage of the tax benefits of cost segregation, a cost segregation study must be performed. This study is performed by a team of CPAs, engineers, and other experts. Here’s how a cost segregation study works.

During the study, your team of professionals will do an initial analysis of the property and your tax situation, collect important documentation, complete an in-depth cost segregation analysis of the components of your property, and provide a comprehensive report with the team’s findings.

It is important to note that cost segregation studies typically take around 60 days to complete, and there is a large upfront cost. However, many business and property owners find the tax benefits of a cost segregation study are worth the expense.

It is also possible to do a cost segregation study yourself. However, many taxpayers will find that learning IRS guidelines, analyzing the property, and completing other steps required for a comprehensive study is time-consuming and leaves too much room for costly errors.

Benefits & Drawbacks Of Cost Segregation

Before you determine if this tax strategy is right for you, weigh out the pros and cons of cost segregation.

The cost savings as a result of cost segregation are great. Cost segregation can help reduce your tax liability and increase immediate cash flow. You may even be eligible to use cost segregation to depreciate assets put in use in prior years without the need to file an amended tax return.

Cost segregation does have its downsides, as well. Cost segregation studies are expensive, ranging anywhere from $5,000 to $15,000+.

These studies are also quite time-consuming, generally taking around 60 days to complete.

If your deductions are calculated inaccurately, you will be liable for penalties and interest to the IRS. This is why it’s important to make sure you choose the best cost segregation team to ensure accuracy.

Next Steps To Get Started With Cost Segregation

If you opt to move forward after weighing out the pros and cons, the next step is to find the best cost segregation services for your study. Since there is a large upfront investment, it’s critical to do your research to hire the right cost segregation company for the job.

Once you’ve found a team to work with, these experts will analyze your tax situation and perform an analysis to determine if your property is a good fit for cost segregation.

After receiving your report, these experts may also provide additional guidance, next steps, and information about what to expect when you file your next tax return. Once the study has been completed, you’ll be able to save annually on your tax liability and won’t have to complete another study until you build or acquire a new property or undergo a remodeling project.