Cost Segregation Studies: Unlocking Tax Savings for Real Estate Investors

7 Minute Read
Posted by Randy Eickhoff on Nov 22, 2023 2:00:00 PM

What is a Cost Segregation Study?

Simply put, a cost segregation study is an engineering-based analysis that identifies assets within a commercial building, which can be depreciated over shorter periods, typically 5, 7, or 15 years, instead of the standard 39-year period. By conducting a cost segregation study, commercial property owners and real estate investors can benefit from income tax savings, increased cash flow, and other tax benefits.

Why Conduct a Cost Segregation Study?

Cost segregation is a tax deferral strategy that can provide significant tax savings for real estate owners. By accelerating depreciation deductions on property-related costs, a cost segregation study can reduce current tax liabilities and increase cash flow, making it an effective tax strategy for property owners. In addition, cost segregation studies can help identify other tax benefits available to real estate investors, further enhancing their return on investment.

The Importance of a Quality Cost Segregation Study

A well-executed cost segregation study by tax experts can provide significant tax savings and improve cash flow for commercial property owners. However, a poorly executed cost segregation study performed alone can result in missed opportunities for tax savings or even potential tax penalties. Therefore, it is crucial to work with a cost segregation specialist who can perform a comprehensive cost segregation analysis and produce a detailed cost segregation report that meets IRS guidelines.

Can I Perform My Own Cost Segregation Study?

While it may be tempting to perform your own cost segregation study in order to save on professional fees, doing so is not advisable for several reasons. Firstly, a quality cost segregation study is a complex and specialized field that requires a deep understanding of tax law, construction, engineering, and accounting processes. 

Conducting the study without the necessary expertise can lead to errors or omissions, potentially jeopardizing your tax benefits and exposing you to potential IRS scrutiny. Secondly, an independent third-party analysis from a reputable cost segregation provider can lend credibility to the benefits generated, making it more likely to withstand an IRS audit. In essence, working with an experienced cost segregation specialist ensures the accuracy and compliance of the study and results, maximizing your tax savings while minimizing the risk of penalties.

How Does Cost Segregation Work?

To answer the question, "How does cost segregation work?" one must understand that cost segregation involves analyzing the costs of a commercial property and reallocating them into various asset classifications, such as tangible personal property, land improvements, or real property. This process enables the separation of the building structure and the personal property within the building, accelerating the depreciation expense of the personal property into shorter tax lives (or immediately using bonus depreciation), reducing their tax burden and increasing cash flow.

To better understand this complex topic, let's delve into the specific steps involved in conducting a cost segregation study. The process starts with a thorough analysis of the property and its associated costs, ultimately leading to a reallocation of these costs into various asset classifications. This enables property owners to maximize depreciation deductions and minimize tax liabilities, ultimately increasing cash flow.

  1. Data Collection and Analysis: A cost segregation specialist will begin by gathering relevant information about the property, including construction cost details, closing documents, property records, building plans, lease agreements, and other tax records. This data serves as the basis for the cost segregation analysis, which seeks to identify significant property characteristics and related costs.
  2. Asset Identification and Classification: The cost segregation specialist will then examine the building components and their associated costs to identify assets that qualify for accelerated depreciation. These will include tangible personal property, such as mechanical systems, electrical installations, and special-purpose equipment, as well as land improvements, like landscaping and parking lots.
  3. Cost Allocation: Once the qualifying assets have been identified, the cost segregation engineer will allocate the costs of these assets into their respective asset classifications, following IRS guidelines. This reallocation of costs allows property owners to apply shorter tax lives to a larger portion of their real estate investment, leading to greater depreciation deductions and tax savings.
  4. Cost Segregation Report: After the cost segregation analysis is complete, the specialist will prepare a detailed cost segregation report, outlining the findings of the study and supporting the reallocation of costs. This report should adhere to IRS guidelines and provide sufficient documentation to withstand an IRS review, if necessary.
  5. Implementation and Tax Savings: With the cost segregation report in hand, property owners can work with their tax professional to incorporate the accelerated depreciation deductions into their tax return, reducing their taxable income and tax liability. This can lead to significant tax savings and improved cash flow for the property owner.

A well-executed cost segregation study allows commercial property owners and real estate investors to take advantage of accelerated depreciation deductions, leading to tax savings and increased cash flow. By understanding how cost segregation works and partnering with a knowledgeable cost segregation services provider, property owners can optimize their tax positions and maximize the benefits of their real estate investments.

Eligibility for Cost Segregation Studies

Cost segregation studies can be conducted on a wide range of real estate assets, including new construction projects, renovations/expansion projects, purchased properties, leasehold improvements, look-back properties, and real property stepped-up through an estate. To qualify for a cost segregation study, the property must be a commercial property, such as an office building, placed in service after December 31, 1986.

Can a Cost Segregation Study Be Used for Residential Rental Property?

Yes, you can conduct a cost segregation study for residential properties. Residential rental properties are depreciated over 27.5 years for income tax purposes. However, a cost segregation study can identify assets within the property that qualify for shorter depreciation periods, such as 5 or 15 years. By accelerating depreciation deductions, property owners can reduce their taxable income and tax liability, resulting in significant tax savings and improved cash flow. It is essential to work with a qualified, cost segregation study provider to ensure the study's accuracy and compliance with tax regulations.

Benefits of a Cost Segregation Study

By conducting a cost segregation study, commercial real estate owners and investors can unlock numerous tax benefits, including:

  1. Accelerated Depreciation Deductions: By identifying and reclassifying assets with shorter tax lives, a cost segregation study can accelerate depreciation deductions, resulting in a lower taxable income and reduced tax liability.
  2. First-Year Tax Savings: A cost segregation study can increase first-year tax savings by identifying additional depreciation deductions that can be claimed in the initial year of property ownership. This also results in improved near-term cash flow.
  3. Bonus Depreciation: Cost segregation studies can also help property owners take advantage of bonus depreciation, allowing them to claim additional depreciation deductions on qualifying assets in the year they are placed in service.
  4. Look-Back Studies: A cost segregation study can be performed on properties acquired in prior years, allowing property owners to claim missed depreciation deductions and further reduce their tax liability.
  5. Improved Cash Flow: The tax savings generated by a cost segregation study can increase cash flow, providing property owners with additional funds for reinvestment or other purposes.

What Is the Methodology for a Cost Segregation Study?

There are several methodologies employed in a cost segregation study, each with its own unique approach to analyzing and classifying property costs. Some of the most commonly used methodologies include:

  1. Survey or Letter Method: This method relies on cost estimates obtained from contractors and subcontractors involved in the construction or renovation of the property.
  2. Rule of Thumb: This approach is based on the preparer's experience and may utilize little to no documentation. It is less precise than other methods and may not meet stringent IRS guidelines.
  3. Detailed Engineering From Actual Cost Records: Primarily used for new construction projects, this method analyzes real costs associated with the project by examining actual cost records, ensuring greater accuracy.
  4. Residual Estimation: This method focuses on determining the costs of short-lived assets but does not provide a comprehensive analysis of all property-related costs.
  5. Sampling or Modeling: This approach uses models to analyze structures with similar appearance, use, and construction. However, it may have issues with accuracy and validity due to its reliance on assumptions and generalizations.
  6. Detailed Engineering Cost Estimate: Similar to the detailed engineering from actual cost records, this method estimates costs instead of using real costs. It requires a deep understanding of construction processes and materials to generate accurate estimates.

Each of these methodologies is chosen based on the preparer's preference, the specific property being analyzed, and the availability of information to complete the study. It is essential to select the most appropriate method to ensure a high-quality cost segregation study that adheres to IRS guidelines and maximizes tax savings.

Selecting a Cost Segregation Provider

When choosing a cost segregation services provider, it is crucial to work with a specialist who has expertise in tax law, construction, engineering, and accounting processes related to property classifications. They should be able to demonstrate a history of successful cost segregation studies for clients and produce detailed cost segregation reports

About the Author

Acena Consulting Founder and Head Coach, Randy is a licensed CPA and has worked with over 200 companies on various tax credits and other government incentives including multinational technology firms, as well as small privately held manufacturing, sports, and technology companies.

Randy Eickhoff

Randy Eickhoff

Acena Consulting President Randy Eickhoff, licensed CPA, has partnered with more than 200 companies during more than 20 years of experience securing tax credits and other government incentives. His corporate partners range from multinational technology firms to smaller, privately held manufacturing, sports, and technology enterprises.