What is cost segregation?
Cost segregation is a useful tax strategy that allows real estate investors who have acquired, constructed, or purchased land or real property to reduce their taxable income by having a cost segregation analysis completed on the property. Cost segregation can equate to significant tax savings, depending on the property.
This process converts certain components of a non-residential or residential rental property into tangible personal property, which can accelerate depreciation. As a result, the property owner’s income tax rate can be lowered because they are able to write off assets at a more accelerated rate than traditional straight depreciation limits allow, increasing their business’s cash flow and profitability.
If real property is reclassified as 5-, 7- and 15-year personal property, it may qualify for 30% and 50% bonus depreciation. This bonus depreciation applies to new property in the first year it is placed in service. The magnitude of this additional allowance in the first year can be enormous.
For example, a shift of $1 million from 39-year property to 5-year property can augment first-year depreciation deductions by a whopping $575,000 ($25,000 vs. $600,000). The resulting cash flow can provide the capital for numerous other projects.
How a cost segregation study works
A cost segregation analysis should be completed by a professional with experience in engineering, architecture, construction, and tax accounting who can provide a formal analysis.
The analysis separates certain qualified items normally considered to be real property and includes, for example:
- The electrical system.
- Specialized kitchen equipment.
- Wall coverings.
- A concrete slab floor.
- The ventilation system.
- Special plumbing.
- Lighting fixtures.
- The phone system.
- The computer system.
- Process piping.
- Storage tanks.
The recovery or depreciation period is also separated out for these items. Qualified assets will vary by property and project type.
Who do cost segregation studies benefit?
Because a cost segregation analysis can be expensive, they are not right for everyone. They are typically only used by commercial real estate investors or rental property owners with significant real estate activity that would benefit from a notable reduction in their federal income tax rate.
If your business is not generating substantial income or the tax savings a cost analysis would provide will not exceed the initial cost, it’s unlikely a cost segregation study is right for you.
When should a cost segregation study be conducted?
Most professionals recommend completing a cost segregation study immediately after the purchase, remodel, or construction of a property or within the first year thereafter for maximum tax benefits.