Cost segregation is an accounting and tax planning strategy designed to help commercial property owners lower their tax liabilities and increase cash flow by identifying assets that may qualify for faster depreciation rates (and resulting tax benefits) in a shorter amount of time. Depreciable assets (those that lose value over time) like real estate allow commercial and residential property owners to take advantage of tax savings on depreciation over time, currently at 39 years for commercial properties, and 27.5 years for residential properties. The cost segregation process allows real estate owners to reclassify assets that are eligible for a shorter depreciation period than the standard 39 and 27.5 years (also known as accelerated depreciation). The purpose of a cost segregation study is to identify assets like land improvement investments, which may serve to lower the depreciation period for owners by anywhere from five to 15 years.
What You Need to Know About Cost Segregation Studies
Cost segregation is not a do-it-yourself approach to tax savings and compliance. It is an engineering-based analysis designed to identify segments of a commercial property that may be eligible for legitimate reallocation in compliance with U.S. tax law. The good news is that you don't have to be a large scale commercial real estate owner to enjoy the tax benefits and savings of cost segregation. Property owners with improvements expenditures as low as $500,000 are now viable candidates for cost segregation studies (compare that to the $5-6 million average improvement expenditures starting point of the past).
Benefits of a Cost Segregation Study for Taxpayers and Real Estate Owners
Again, the purpose of a cost segregation study is to help commercial property owners obtain depreciation savings in a shorter amount of time. Consider the following example from Commercial Investment Real Estate (CIRE) Magazine:
The best way to illustrate the effects of cost segregation is to compare a property with and without a study. For example, a taxpayer purchases a strip mall for $1.3 million, excluding land and personal property. If there is no cost-segregation study, the taxpayer enters the cost into the fixed-asset system as 39-year property. After the first five years, the taxpayer has accumulated $154,622 in depreciation expenses. However, consider the same property using cost segregation. After thorough engineering analysis combined with an understanding of what qualifies as short-life property as defined by Internal Revenue Code Section 1245, they can reclassify the strip mall into a five-year ($260,524), 15-year ($348,590), and 39-year ($718,457) property. After the first five years, the taxpayer has a total of $460,545 in accumulated depreciation expense.
The obvious difference is that the taxpayer has increased the accumulated depreciation expense by $305,000. With a cost-segregation study, the taxpayer has taken the majority of his depreciation up front and realizes that a dollar saved in the first five years is worth more than the same dollar in 16 years. As a result, the taxpayer has a net present value savings of almost $100,000.
On average, a cost segregation study can lead to shifting 20% to 50% of the cost of depreciation assets from the 39-year bracket down to the five-to-15 year asset class. Overall potential savings include:
- Reduced taxable income and increased tax savings
- Greater cash flow and operating capital
- Reinvestment opportunities and funding for existing or new projects
The Nuts and Bolts of a Cost Segregation Study
A number of factors will be examined to determine the portion of building acquisition and construction costs that qualify for reallocation in the shorter life asset class, including:
- Onsite evaluation of the property by a team of qualified engineers
- Review and analysis of construction plans and blueprints
- Review of financials and related expenses
The review process is comprehensive, and professionals in construction and property development get involved in the study, including carpenters, architects, developers, electricians, and builders.
Here is another example of the potential increase in tax benefits from a cost segregation study from BiggerPockets:
Let’s say you purchase a 15-unit multifamily asset for $606,000. The land is valued at $121,000, leaving a depreciable basis of $485,000 for the buildings. Without cost segregation, the owners will depreciate the buildings on a straight line basis over 39 years. This comes out to $485,000 ÷ 39 = $12,436 that can be depreciated annually.
At a 48% tax rate, this results in first-year (and every year) tax reductions of $5,969. With a cost segregation study in place, in this example, owners will be able to depreciate almost 43% of the $485,000 in an accelerated manner—in 5-year, 7-year, and 15-year buckets.
This means that depreciation is accelerated for about $208,000 of the total. This results in accelerated depreciation of $177,343 in the first five years, compared to straight line depreciation of $62,179 (5 x $12,436) without cost segregation.
Is a Cost Segregation Study Right for You?
In most cases, any commercial property owner subject to state and federal taxes is eligible for a cost segregation study. Qualified properties include warehouses, restaurants, multi-family units, retail buildings, medical space and apartment complexes.
Simply put, if you own commercial property and meet certain thresholds, the cost segregation process can put more money in your hands, as much as a decade or two ahead of schedule. Contact the tax professionals at Goldin Peiser & Peiser to discuss a cost segregation study or for other tax saving strategies for your business.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.