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Cost Segregation: A Tax Strategy for Business Owners to Help Accelerate Depreciation

Did you just open a new facility or renovate your business office building? Instead of taking the overall real estate deduction, you may consider performing a cost segregation study and analysis.

In this article, we’ll break down cost segregation, when it applies, and when it can be a useful tax strategy for business owners.

Dave and Drew break down the ins and outs of cost segregation as it may impact your real-estate tax deductions. 

Check out our tax strategies checklist for business owners. Includes charts  for optimizing your compensation planning and 13 core strategies to consider →

 

What is Cost Segregation?

What is Cost Segregation? Cost segregation is a tax strategy that involves identifying and reclassifying assets within a property to maximize depreciation deductions. When a business owner purchases or constructs a property, the traditional method is to depreciate the entire property over a standard 39-year period (for commercial properties) or 27.5 years (for residential rental properties).

However, cost segregation takes a more detailed approach. It involves conducting a thorough engineering-based study to identify assets within the property that can be depreciated over shorter periods, such as 5, 7, or 15 years. These assets may include things like electrical systems, plumbing, landscaping, and specialized equipment.

By accelerating the depreciation of these assets, business owners can claim larger tax deductions in the early years of property ownership, which can significantly reduce their tax liability and improve cash flow. This is different from traditional depreciation methods, which spread the deductions evenly over the entire 39-year or 27.5-year period.

Cost segregation can be applied to various types of properties, including:

  1. Commercial real estate (office buildings, retail centers, warehouses)
  2. Residential rental properties (apartment complexes, multifamily housing)
  3. Manufacturing facilities
  4. Hotels and restaurants
  5. Healthcare facilities

In general, any property that has a mix of real property (buildings) and personal property (equipment, fixtures, etc.) can potentially benefit from a cost segregation study. The most significant tax savings are often realized on newer properties or those that have been recently renovated or expanded.

Benefits of Cost Segregation for Business Owners 

Cost segregation offers several compelling benefits for business owners who own real estate:

  1. Accelerated depreciation: By reclassifying assets into shorter depreciation life categories, business owners may be able to claim larger depreciation deductions in the early years of property ownership. This accelerated depreciation allows owners to frontload their deductions, providing significant tax savings in the near term.
  2. Increased cash flow: By reducing their tax liability through accelerated depreciation, business owners can potentially free up cash that would otherwise be paid in taxes. This increased cash flow can be reinvested into the business, used to pay down debt, or allocated to other growth opportunities.
  3. Reduced tax liability: The larger depreciation deductions generated through cost segregation may directly translate to a lower tax bill. This reduction in tax liability can be substantial, especially for owners of high-value properties or those in higher tax brackets.
  4. Potential to claim "catch-up" depreciation: If a business owner has owned a property for several years without utilizing cost segregation, they may be able to claim "catch-up" depreciation. This involves conducting a cost segregation study on the property and claiming the accelerated depreciation that they missed out on in previous years. By claiming this catch-up depreciation in the current year, owners can realize potential tax savings and a boost in cash flow.

How Cost Segregation Works

Cost segregation is a multi-step process that involves identifying, classifying, and calculating depreciation for assets within a property.

Step 1: Identifying assets that qualify for accelerated depreciation 

The first step in cost segregation is to identify assets within the property that can be depreciated over shorter periods than the standard 39-year (commercial) or 27.5-year (residential) timelines. 

These assets are typically personal property or land improvements, such as furniture, fixtures, equipment, landscaping, and parking lots. By separating these assets from the building itself, owners can potentially take advantage of shorter depreciation schedules.

Step 2: Classifying assets into shorter depreciation life categories

Once the assets have been identified, they are classified into the appropriate depreciation life categories, such as 5-year, 7-year, or 15-year. The classification is based on the asset's expected useful life and is guided by IRS rules and regulations. 

For example, carpeting and appliances may fall into the 5-year category, while certain landscaping and site improvements may be classified as 15-year assets.

Step 3: Calculating the depreciation deductions

After the assets have been identified and classified, the final step is to calculate the depreciation deductions for each category. This involves determining the cost basis for each asset and then applying the appropriate depreciation method (e.g., straight-line or accelerated) over the assigned useful life. 

The resulting depreciation deductions are then claimed on the owner's tax return, potentially reducing their taxable income and, consequently, their tax liability.

Conducting a Cost Segregation Study

A cost segregation study is the process of analyzing a property to identify assets that qualify for accelerated depreciation. 

Here's what you need to know about conducting a study:

When to consider a cost segregation study

Business owners should consider a cost segregation study when they acquire, construct, or substantially renovate a property. The study is potentially most beneficial for properties with a cost basis of at least $500,000, as the potential tax savings are more likely to justify the cost of the study. 

Additionally, owners who have held a property for several years without utilizing cost segregation may benefit from a "look-back" study to claim missed depreciation deductions.

The process of a cost segregation study

A cost segregation study typically involves a detailed analysis of the property, including a review of construction documents, blueprints, and invoices. A team of engineers and tax professionals will identify and classify assets, determining their appropriate depreciation life categories. 

The study will also calculate the cost basis for each asset and provide a detailed report outlining the findings and potential tax savings.

Hiring a professional to perform the study

Given the complexity of cost segregation and the need for specialized knowledge, it's crucial to hire a qualified professional to conduct the study. Look for firms with experience in cost segregation and a team that includes both engineers and tax experts. 

A reputable provider will have an established track record of delivering accurate studies and substantial tax savings for their clients. While the cost of a study can vary based on the size and complexity of the property, the potential tax benefits often far outweigh the initial investment.

By conducting a cost segregation study with the help of qualified professionals, owners can potentially identify and reclassify assets within their properties to take advantage of shorter depreciation schedules.

Risks and Considerations

While cost segregation can provide significant tax benefits, business owners should also be aware of the potential risks and considerations associated with this strategy:

  • Potential for IRS audits: 

Cost segregation studies are a well-known tax strategy, and the IRS closely scrutinizes tax returns that claim significant depreciation deductions. While a properly conducted study should withstand IRS review, there is always a risk of an audit. If the IRS determines that assets were improperly classified or depreciated, the owner may face penalties and interest charges in addition to the back taxes owed. 

To mitigate this risk, it's essential to work with experienced professionals who follow IRS guidelines and best practices.

  • Record-keeping requirements: 

Implementing a cost segregation strategy requires detailed recordkeeping to support the asset classifications and depreciation deductions claimed on tax returns. Business owners must maintain accurate records, including the cost segregation study report, asset schedules, and supporting documentation (e.g., construction documents, invoices). 

These records should be kept for the entire depreciation period of the assets, which can be up to 39 years for commercial properties. Failure to maintain proper records can lead to issues in the event of an IRS audit.

  • Costs associated with a cost segregation study:

Conducting a cost segregation study involves an upfront investment, as owners must hire qualified professionals to analyze the property and prepare the necessary reports. The cost of a study can vary depending on the size, complexity, and location of the property, as well as the provider's fees. 

However, the potential tax savings generated by cost segregation often far exceed the initial cost of the study. Business owners should carefully consider the expected return on investment before proceeding with a study and should view it as a long-term investment in their property's tax efficiency.

While there are potential challenges associated with this approach, many owners find that the potential benefits of accelerated depreciation and improved cash flow outweigh the risks, making cost segregation a valuable tax savings tool.

Cost Segregation: Your Next Steps

To get started with cost segregation, consider the following steps:

  1. Consult with a tax professional or financial advisor to determine whether cost segregation aligns with your overall tax strategy and financial goals.
  2. Identify properties in your portfolio that may be good candidates for a cost segregation study, such as those with a cost basis of at least $500,000.
  3. Research and select a qualified cost segregation provider with a notable track record of delivering accurate studies and potential tax savings for their clients.
  4. Gather the necessary documentation, including construction documents, blueprints, and invoices, to support the cost segregation study.
  5. Work with your chosen provider to conduct the study and implement the findings on your tax returns.

Remember, while cost segregation may be able to provide significant benefits, it's important to carefully consider the potential risks and costs associated with this strategy. 

By working with experienced professionals and maintaining accurate records, you can potentially maximize the benefits of cost segregation while minimizing potential challenges.

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