Do You Need a Cost Segregation Study?

Navigating the complex world of real estate tax strategies can be daunting. By default, real estate is depreciated over the useful life of that asset. Investors realize the losses from depreciation on a gradual basis – unless they obtain a cost segregation study.

With a cost segregation study, property owners can identify and reclassify individual components of their property into different asset classes. This allows the Taxpayer to accelerate each asset’s depreciation deductions, pulling future tax savings forward into the current year.

Here’s what John Hanning, Principal at Specialty Tax Group and former President of the American Society of Cost Segregation Professionals, has to say:

“A cost segregation study can significantly increase your cash flow in the short term and will provide long-term benefits due to the time value of money concept. The time value of money concept states that a dollar today is worth much more to your business than 39 or 27.5 years from now.”

Whether you’re a seasoned real estate investor or a first-time property owner, a cost segregation study can provide a strategic advantage in managing your tax obligations and achieving your financial goals.

What is a Cost Segregation Study?

A cost segregation study identifies and reclassifies the individual components of a building or property into different asset classes with varying depreciable lives.

Typically, a property is treated as a single asset depreciating over a standard period (e.g., 39 years for commercial buildings). A cost segregation study breaks that property into multiple components, segregating assets like land improvements, equipment, and personal property from the building itself. Once segregated, these assets can be depreciated over 5, 7, or 15 years, depending on the useful life of that asset. 

Over time, this reduces the tax burden on property owners and significantly improves cash flow.

“Carving out personal property and land improvements from the bricks & sticks is the primary goal of cost segregation. A cost segregation professional pulls together complex tax law & engineering experience to separate components of the property that are decorative, movable, reusable, or specialized to the tenant business from the long-life Sec 1250 property to create current year cash flow.”

–– John Hanning, Principal at Speciality Tax Group and former President of the American Society of Cost Segregation Professionals (ASCSP)

The cost segregation study process involves three main steps:

1. Asset Identification: A specialized cost segregation firm or provider conducts a detailed analysis to identify and segregate the various components of the property.
2. Valuation: Using industry guidelines, standards, and data, the firm determines the appropriate values for each segregated component and prepares a report summarizing their findings. 
3. Depreciation Calculation: Once the components are identified and valued, a CPA calculates the depreciation for each asset class based on its specific depreciable life, method, and convention.

By accelerating the depreciation deductions, property owners can pull forward depreciation and realize significant tax savings.

When Is a Cost Segregation Study Valuable? 

With the scheduled phase-out of bonus depreciation over the next few years, cost segregation studies are becoming even more crucial for property owners. Bonus depreciation allows taxpayers to deduct a significant portion (currently 60% for properties placed in service in 2024) of the cost of certain assets in the year they were placed in service, in addition to regular depreciation deductions. 

While a cost segregation study can be beneficial for many property owners, there are certain variables that investors should consider before choosing to do a cost segregation:

• Hold Time: Cost segregation studies are most beneficial for medium to long-term property holdings. For example, if you plan to hold a rental property for ten years, the accelerated deductions from a cost segregation study could result in substantial tax savings early in the hold period. Cost segregation studies tend not to be a good fit for hold periods of less than two years. For these shorter holds, the cost of doing the study may outweigh the tax benefits. A Net Present Value (NPV) calculation can help highlight the required hold time.
• Properties with Substantial Depreciable Assets: Properties with a high percentage of assets that can be reclassified into shorter depreciable lives, such as land improvements like landscaping or fencing and equipment like process-supporting HVAC systems, may be ideal candidates for a cost segregation study.
• Cost-Benefit Analysis: The potential tax savings from conducting a cost segregation study should outweigh the cost of performing it. While the upfront cost may seem significant, evaluating the long-term benefits over the property’s holding period is important. An experienced tax advisor may be especially helpful in conducting this analysis. 
• Property Improvements or Renovations: When making improvements or renovations to an existing property, a cost segregation study can help segregate and accelerate the depreciation of the new components. For example, if you’re adding a new parking lot, landscaping, or equipment, the study could maximize the deductions on those additions. Additionally, following the CARES Act, any interior non-structural improvements made to a property qualify for bonus depreciation under the classification of qualified improvement property. Property in this classification currently has a depreciable life of 15 years.
• Offsetting Gains or Income: For investors with multiple properties, a cost segregation study can help offset gains from property sales or other passive income. For example, if you own multiple rental properties and sell one, those profits would be considered taxable income, increasing your tax liability. Conducting a cost segregation study on another property would enable you to offset some element of these gains by taking advantage of depreciation deductions.
• Passive Activity Limitations: Taxpayers must note that unless they are a real estate professional, the losses achieved from a cost segregation study can only be applied against their passive income due to passive activity rules. In essence, that means that taxpayers with high levels of active W-2 or business income cannot use a cost segregation study to reduce the taxes they owe on this income.  

Misconceptions Regarding Cost Segregation Studies

While cost segregation studies are a legitimate and powerful tax planning strategy, several common misconceptions about them prevail. 

By addressing these misconceptions head-on, you can make informed decisions and maximize the benefits of a cost segregation study.

Cost Segregation Studies Don’t Create Additional Depreciation

One common misconception is that a cost segregation study generates new or additional depreciation deductions beyond what existed previously. This is not the case. 

A cost segregation study allows assets to be depreciated over shorter periods by identifying and segregating various components of a property into different asset classes with varying depreciable lives. Although it doesn’t create new deductions, the resulting acceleration of deductions can generate significant tax savings for property owners.

Tax Savings Don’t Necessarily Mean Zero Taxes Owed

The potential tax savings generated through cost segregation do not automatically eliminate all tax liabilities. Other factors, such as passive activity limitations, still apply, limiting the ability to fully utilize the additional deductions. 

For example, taxpayers with both active and passive income face limitations on the deductions they can claim through a cost segregation study. It’s essential to work with experienced tax professionals who can help navigate these complex requirements and ensure compliance while maximizing the benefits of cost segregation.

A Cost Segregation Study Can Be Beneficial for Long-Held Properties

Another common misconception is the belief that a cost segregation study will not be beneficial to a property that has been owned for more than a handful of years. In reality, cost segregation studies can be completed on properties placed into service as far back as 1987, though more benefit will be gained from properties more recently acquired or constructed.

Cost Segregation studies can be used to identify improperly classified assets that have been previously placed in service, allowing the taxpayer to complete an Accounting Method Change to decrease their tax liability.

Hanning comments:

“I’m often asked how far back taxpayers should look when considering a cost segregation study. My reply is generally ten years. There’s still enough time remaining in the NPV calculation to support the cost of the study and, often, it is typical that the property will be in a similar state as the day it was placed in service, improving the supportability of the study.”

Valuations Must Be Supported

The valuations in a cost segregation study must be supported by robust engineering reports and data, not arbitrary numbers or the ‘Rule of Thumb’ approach. This is not an area where you should attempt to do it yourself; instead, work with an experienced cost segregation study provider.

To minimize audit risk and withstand scrutiny from tax authorities, maintain proper documentation regarding your cost segregation study and comply with all relevant industry standards. Proper documentation includes items such as new construction cost information, purchase price allocations, site visit documentation, leasing agreements, and appraisals.

Working with reputable, certified members of ASCSP and experienced tax professionals can help ensure that the study’s valuations and classifications are well-supported and defensible. Many specialty cost segregation firms will also provide audit support hours as a part of the project deliverable package.

Smith + Howard: Real Estate Tax Experts

Experienced tax advisors play a crucial role in identifying opportunities for cost segregation studies. By working closely with specialized firms and providers, they help to ensure a smooth implementation for their clients. 

Smith + Howard’s experienced tax advisors can help you analyze your specific situation and the potential benefits of a cost segregation study and connect you with a trustworthy resource to conduct the study. Once it’s complete, your Smith + Howard advisor will help you understand the results and implement them on your tax returns. 

To learn more about how Smith + Howard can help you build an effective tax strategy for your real estate portfolio, contact an advisor today.