A cost segregation study can create significant tax savings by accelerating depreciation deductions, but the study itself comes at a cost. So, is it worth it?
The answer depends on the property, the amount of depreciation that may be accelerated, and your tax situation. You can estimate the potential return on investment (ROI) by comparing the expected tax savings with the cost of the study.
Here's how to calculate it.
What Is a Cost Segregation Study?
A cost segregation study is a tax analysis that identifies components of a commercial or investment property that may qualify for shorter depreciation periods than the building itself.
Commercial real estate is generally depreciated over 39 years, while residential rental property is generally depreciated over 27.5 years. A cost segregation study examines the property's components to identify certain assets that may qualify for shorter recovery periods, such as 5, 7, or 15 years.
Depending on the property and when it was acquired and placed in service, certain qualifying assets may also be eligible for additional first-year depreciation. Current federal tax law provides a permanent 100% additional first-year depreciation deduction for certain qualified property acquired and placed in service after January 19, 2025, subject to applicable requirements and elections.
By accelerating depreciation deductions, a cost segregation study may allow property owners to claim larger deductions earlier in the property's life. Those deductions can reduce taxable income and potentially improve after-tax cash flow.
How Do You Calculate Cost Segregation ROI?
For purposes of this article, we're calculating the potential return on the cost of the cost segregation study itself. This is different from the property's overall investment return.
A simple way to estimate the potential ROI is:
ROI = (Estimated Tax Savings − Cost of Study) ÷ Cost of Study × 100
For example, if a study costs $5,000 and generates an estimated $25,000 in tax savings:
($25,000 − $5,000) ÷ $5,000 × 100 = 400% ROI
Determining the estimated tax savings requires a few steps.
Step 1: Determine the Cost of the Study
Start with the amount you'll pay for the cost segregation study.
Study fees vary based on factors such as property type, property size, value, number and complexity of assets, and the scope of the analysis.
For this example, assume the study costs $5,000.
Step 2: Estimate the Accelerated Depreciation
Next, determine how much of the property's depreciable basis may qualify for accelerated depreciation.
For example, assume a commercial property was purchased for $2 million, with a $1.8 million depreciable basis after excluding land. A cost segregation study may identify a portion of that basis that qualifies for shorter recovery periods and potentially additional first-year depreciation, depending on the property's acquisition and placed-in-service dates and applicable tax rules.
A professional cost segregation study is used to identify and document the qualifying assets.
Step 3: Estimate the Potential Tax Savings
Once the accelerated depreciation is estimated, you can evaluate its potential tax impact.
For a simplified illustration, assume the study identifies $400,000 in accelerated depreciation deductions that the owner can use in the current year. If the owner's applicable marginal federal tax rate is 30%, the estimated federal tax savings would be:
$400,000 × 30% = $120,000
This is a simplified example, not a prediction of actual tax savings. Results can vary based on the taxpayer's marginal tax rate, whether the deductions can be used in the current year, passive activity rules, state and local taxes, other deductions, bonus depreciation elections, and other tax considerations.
Step 4: Calculate the Potential ROI
Now compare the estimated tax savings with the cost of the study.
Using our example:
- Cost of study: $5,000
- Estimated accelerated depreciation: $400,000
- Illustrative marginal federal tax rate: 30%
- Estimated federal tax savings: $120,000
- Estimated net benefit after study cost: $115,000
The estimated ROI would be:
($120,000 − $5,000) ÷ $5,000 × 100 = 2,300%
A 2,300% ROI is not typical for every property. The result will vary based on the property's depreciable basis, qualifying assets, tax situation, applicable depreciation rules, and cost of the study.
What Can Affect Cost Segregation ROI?
The ROI calculation is straightforward, but several factors can change the result.
Property Value and Depreciable Basis
A larger depreciable basis generally provides more opportunity for accelerated depreciation.
Land must be excluded because it is not depreciable. The remaining basis may include the building and other depreciable property, which the cost segregation analysis can evaluate for different recovery periods.
Your Tax Situation
Your ability to use the deductions is an important part of the calculation.
If you have sufficient taxable income, accelerated depreciation may produce meaningful current-year tax savings. If you cannot currently use the deductions, the immediate cash-flow benefit may be different.
Your tax advisor can help determine how the deductions fit into your overall tax situation.
When the Property Was Acquired and Placed in Service
The property's acquisition and placed-in-service dates can affect which depreciation rules apply, including eligibility for additional first-year depreciation.
Because depreciation rules can change, the applicable rules should be evaluated based on the specific property and tax year.
Expected Holding Period
Your expected holding period is another factor to consider.
Accelerating depreciation can increase deductions in earlier years, but the timing of those deductions should be considered alongside the property's expected holding period and the tax consequences of a future sale.
Depreciation Recapture
When depreciable property is sold at a gain, some of that gain may be subject to depreciation recapture under applicable tax rules. The treatment depends on the type of property and the depreciation involved.
This does not necessarily eliminate the benefit of accelerated depreciation, but it should be considered when evaluating the strategy over the property's full investment period.
When Is a Cost Segregation Study Worth Considering?
There is no single property value or tax savings threshold that makes a cost segregation study worthwhile for every investor.
A study may be particularly worth considering when:
- You recently purchased or constructed a commercial or investment property.
- The property has a relatively high depreciable basis.
- The property has significant improvements or components that may qualify for shorter recovery periods.
- You have sufficient taxable income to benefit from additional depreciation deductions.
- You want to improve near-term after-tax cash flow.
- You plan to reinvest tax savings into your property or other investments.
So, Is Cost Segregation Study Worth It?
A cost segregation study may be worthwhile when the potential tax benefits outweigh the cost of the study and you can effectively use the resulting deductions.
To estimate the potential ROI, start with the property's depreciable basis, estimate the depreciation that may be accelerated, determine the potential tax savings, and compare those savings with the study cost.
If you're considering a cost segregation study, Acena Consulting can help you evaluate the potential benefits and determine whether the strategy makes sense for your property.
Contact Acena Consulting to discuss your property and learn more about cost segregation.
