Cost segregation is a popular tax strategy that real estate investors can use to accelerate their depreciation deductions, increase their cash flow, and reduce their federal and state taxes paid on rental income. A proper cost segregation strategy will front-load your tax deductions into the early years of property ownership and free up capital for further investing. If you or your company have constructed, purchased, or remodeled any real estate, a cost segregation study may be an option for you.
What is a Cost Segregation Study?
A cost segregation study slices up a property in order to identify components that will depreciate faster than the full asset itself. For example, certain millwork, cabinets, and demountable fixtures should be depreciated over five years, instead of the 39-year depreciation life of a commercial building.
Typically, real estate is divided into two categories, Land and Building. The Land does not depreciate, however, the Building depreciates over 27.5 years (if residential) or 39 years (if non-residential). In a cost segregation study, the Building category is further subdivided into Personal Property and Land Improvement. By identifying components as Personal Property and Land Improvements, investors can create significantly shorter tax windows for their properties, ranging from five, to seven, to fifteen years depending on the identified Building components.
How Does a Cost Segregation Study Work?
A cost segregation study unfolds over several steps:
Consultation
While cost segregation studies are a popular strategy, they may not be worthwhile for your company given your circumstances. To ensure your time and money will be well spent, a qualified CPA will consult with you and gain a better understanding of your tax position and the property you want studied. After this consultation, they will offer feedback on whether a cost segregation study will offer a significant enough financial incentive for you to pursue.
Learn More About Your Property
Once it’s been determined that a cost segregation study is beneficial, further analysis will begin on your property. Typically, cost segregation firms will gather information such as an appraisal, a site map, and invoices from construction. They will also want to tour your property, examine blueprints, and break down the costs of the building’s components. This information will be used to identify parts of the building structure that is more appropriately classified into the Personal Property and Land Improvement categories.
Reporting
Once this information is gathered, the cost segregation firm will compile the findings into a report for your business. Typically, this report will include the findings and results of the study, the methodology used while compiling the report, and the tax laws supporting the assessment, in case of an IRS audit.
Can a Cost Segregation Study Help Your Business?
A cost segregation study’s worth is highly variable depending on your situation. It is important to consult with a qualified tax advisor early on in the process. If you or your company have a constructed or purchased a property worth more than $1 million, or you have completed over $500,000 in renovations or remodels, you may make a good candidate for a cost segregation study. There are also resources available to perform mini-cost segregation studies for smaller purchases such as duplexes.
If you intend to hold the property for five or less years, the cost may not be worth the benefit, as accelerated depreciation may be recaptured upon sale.
A cost segregation need only be performed once for each building you own. If you conduct extensive expansions or remodels, another study will need to be performed to ensure you’re getting the maximum benefit and staying on the right side of the IRS. If a cost segregation study was previously performed on a property you now own, the IRS suggests conducting a new one, since the situation may have changed since the study was last performed.
Conclusion
If you have never had a cost segregation study performed on your property, speak with a qualified tax professional about whether you are missing out on tax savings opportunities. While it is possible to conduct a study on your own, there are many pitfalls a professional can help you avoid to properly cost segregate your property. If you have questions regarding a cost segregation study, send me an email and I’d be happy to discuss it further with you.
Read my full article on topics to discuss with your CPA here.
© Clark Nuber PS, 2023. All Rights Reserved.
This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.
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