What is Cost Segregation?
Cost segregation is the process of identifying and classifying components of a property as either real property or personal property. The IRS permits this reclassification for tax purposes, which can result in significant tax savings for the owner of the property.
How Does Cost Segregation Work?
To take advantage of cost segregation, a property must be analyzed at a detailed level by a qualified engineer to separate the building structure and personal property. Examples of personal property that can be separated out include asphalt, landscaping, lighting, some flooring, and much more.
Once the engineering evaluation and analysis is complete, the property owner can then file Form 3115 with the IRS to request a change in their classification of the property if the property was placed in service in a prior tax year. The resulting additional depreciation expense from both the "catch up" of prior depreciation not taken and the reclassification of assets to personal property results in a substantial first-year benefit.
If the property is being placed in service in the year a cost segregation study is completed, no Form 3115 is required and the assets can be placed on the tax return in the appropriate classification and depreciated accordingly.
What Are the Benefits of Cost Segregation?
The primary benefits of cost segregation are significant tax savings, accelerated depreciation, and as a result, increased cash flow. This process results in a higher return on your cash investment and overall reduction in the cost of ownership.
Learn more about the 4 main reasons to consider a cost segregation study here.
What Are the Risks of Cost Segregation?
There are a few downsides associated with cost segregation.
First, the depreciation taken each year on a tax return as expense reduces the overall basis of the property. When there is substantially more depreciation resulting from a cost segregation study, the cost basis of the property will be reduced by that amount.
When the property is sold, depreciation taken must be recaptured as income thereby increasing the taxable income recognized on the sale of the property. It is important to recognize that the increased cash flow taken in the year of the cost segregation study must be "repaid" upon sale.
Second, there is a cost to completing a cost segregation study. The expertise and engineering experience of the cost segregation team requires a fee for the service.
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Cost Segregation Example:
To illustrate how cost segregation can save you money, let's assume you purchased a commercial property for $1,000,000 in 2022 . The real property components of the property are typically depreciated over a 39-year period, while the personal property components can be depreciated over a 5, 7, or 15-year period.
Without cost segregation, your depreciation deduction in the first year would be $25,641 ($1,000,000 / 39). However, if you were to segregate the personal property components of the property and assume these totaled $250,000, your first-year depreciation deduction would be $250,000 as they would be eligible for bonus depreciation. At a 40% combined federal and state tax rate, the tax savings would be $107,692.
In this example, cost segregation would result in a first-year depreciation deduction that is much more impactful than it would be without cost segregation. Throughout the property's useful life, the owner would save tens of thousands of dollars in taxes.
If you own a commercial property, cost segregation could be a great way to save money on your taxes. A cost segregation study can help you to reclassify the personal property components of your property so that they can be depreciated over a shorter period, resulting in significant tax savings. However, it's important to consult with a qualified tax professional before undertaking a cost segregation study, as there are some risks involved.
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