Cost segregation is a tax strategy that allows real estate owners to accelerate depreciation deductions by reclassifying specific components of their property. Typically, commercial or residential rental property is depreciated over a standard period—39 years for commercial property, including Airbnbs, and 27.5 years for residential rental property (long-term leases). However, many property components (such as carpeting, lighting fixtures, and landscaping) have shorter depreciation periods, ranging from 5, 7, or 15 years.

Through cost segregation, real estate owners can separate these shorter-lived assets from the building structure itself, allowing them to depreciate at an accelerated rate. This increased depreciation can create significant tax deductions upfront, immediately boosting cash flow.

How Does Cost Segregation Work?

Cost segregation is performed through an in-depth engineering study that assesses every component of a property. At Acena, our cost segregation specialists and engineers identify property elements that can be reclassified for shorter depreciation. Here’s a simple breakdown of the types of property categories that a cost segregation study may recognize:

• Personal Property (5-7 Years): This includes items such as furniture, carpeting, countertops, and specialized machinery, which depreciate faster than the building itself.

• Land Improvements (15 Years): Landscaping, parking lots, sidewalks, and other exterior improvements are classified separately and have a shorter useful life.

• Building Components (39 or 27.5 Years): These include the primary structure (walls, roof, foundation), which remains on the standard depreciation schedule.

Property owners can front-load depreciation expenses to reduce their taxable income in the early years of ownership by reclassifying parts of a building into shorter asset lives.

Benefits of Cost Segregation for Real Estate Investors

• Increased Cash Flow: By accelerating depreciation, cost segregation can significantly reduce your taxable income, allowing you to retain more cash for reinvestment, renovations, or other business expenses.

• Reduced Taxable Income: The deductions created by accelerated depreciation can offset rental income, reducing your overall tax burden. This can benefit high-income investors looking to lower their effective tax rate.

• Improved Return on Investment (ROI): Cost segregation’s immediate tax benefits can enhance your property’s profitability, resulting in a higher ROI. The additional cash flow from tax savings can be reinvested into new acquisitions, repairs, or value-adding improvements that further boost property value.

• Eligibility for Bonus Depreciation: As part of the 2017 Tax Cuts and Jobs Act, investors are allowed to claim 100% bonus depreciation on qualified assets with a useful life of 20 years or less. This means that assets identified in a cost segregation study can potentially be fully depreciated in the first year of ownership, maximizing the tax benefit in the short term. Bonus depreciation decreases 20% annually beginning in 2023 (80%). 

• Flexibility with Property Lifecycle Planning: Cost segregation is flexible and can be applied retroactively for properties purchased in prior years, allowing investors to “catch up” on missed depreciation. This makes it a valuable option for properties held long-term, as it offers flexibility in managing tax planning over the lifecycle of an asset.

Who Should Consider Cost Segregation?

Cost segregation can benefit a variety of real estate investors, especially those with commercial properties, residential rentals, or mixed-use buildings. Here are some key scenarios where cost segregation might make sense:

• Newly Acquired Property: If you recently acquired a commercial or residential rental property, performing a cost segregation study can help maximize your upfront tax deductions.

• Existing Property: Even if you’ve owned the property for several years, it’s possible to conduct a cost segregation study retroactively, potentially resulting in a large “catch-up” depreciation deduction. Reach out to us, and we can provide you with an Estimate to see the potential savings your property offers.

• Renovated or Expanded Property: If you’ve made significant improvements or expansions, a cost segregation study can help categorize these enhancements into shorter asset lives, creating additional depreciation opportunities.

When to Conduct a Cost Segregation Study

Ideally, a cost segregation study should be done as early as possible after purchasing, placing it in service, or significantly improving a property to maximize the upfront tax benefits. If you’re considering a study for a property you own, consult a tax professional or cost segregation specialist to determine the potential benefits of a retroactive analysis.

Conclusion

Always consult with a tax professional or cost segregation specialist to ensure that this strategy aligns with your investment goals and complies with IRS regulations. With the right guidance, cost segregation can be a game-changer in optimizing your real estate investments.

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Edited by Randy Eickhoff, CPA, Founder & Head Coach at Acena Consulting.