Cost Segregation Study Considerations for Real Estate Investors

What is Cost Segregation?

A Cost Segregation Study can analyze real estate used for residential or commercial purposes, separating the property's value into building and land components. While land cannot be depreciated, residential building property is depreciated over 27.5 years, and commercial building property over 39 years. Residential buildings rented for short-term durations, such as vacation homes or secondary residences rented through platforms like Airbnb or Vrbo, also fall into the 39-year depreciation class.

A Cost Segregation Study provides a detailed analysis of a property's components to identify assets that can be depreciated over shorter tax lives of 5, 7, or 15 years. This process allows property owners to accelerate depreciation deductions, resulting in immediate tax savings at both Federal and State levels. Property components assigned 5, 7, and 15-year lives are also eligible for first-year bonus depreciation, an accelerated first-year deduction for assets with tax lives of 20 years or less. Starting January 1st, 2024, bonus depreciation permits 60% of eligible costs to be deducted in the first year the property is placed into service. The bonus depreciation rates are set to decrease to 40% in 2025, 20% in 2026, and 0% in 2027. Even without bonus depreciation, the shorter tax lives offer significant benefits over the 27.5 and 39-year lives assigned to the buildings.

If passed, proposed legislation under the Tax Relief for American Families and Workers Act of 2024 would restore bonus depreciation to 100% through 2025, and rates would instead decrease by 20% each year starting in 2026. This potential 100% first-year depreciation deduction would further incentivize the use of cost segregation studies in the coming years.

How is a cost segregation study performed?

1. Engagement: The property owner engages a qualified professional or firm to conduct the cost segregation study. Typically, this involves hiring a certified cost segregation specialist, engineer, or other professionals with expertise in tax laws and construction.
2. Site Visit and Data Collection: The cost segregation team reviews the original construction documents, including architectural and engineering drawings, to understand the building's design and construction. The team may also conduct a site visit to gather information about the property. They collect data on the building's components, systems, and construction details.
3. Cost Allocation: The costs associated with the property are categorized into different asset classes based on their recovery periods as defined by the tax code. The team identifies and separates personal property assets, such as lighting, carpeting, and certain building components, from real property assets, like the building structure itself.
4. Cost Segregation Report: The findings and calculations are documented in a detailed cost segregation report. This report provides a breakdown of the reclassified costs, supporting documentation, and the revised depreciation schedule, which reflects the reclassified assets with shorter recovery periods.

Is my situation a good candidate for a cost segregation study?

A cost segregation study is particularly beneficial for certain types of investors and properties. While not an exhaustive list, here are some situations where a cost segregation study might be most beneficial:

• Substantial Real Property Investment: Significant investment in the construction, acquisition, or renovation of commercial real estate are often good candidates. The higher the property value, the greater the potential benefits of accelerating depreciation.
• Recent Construction, Acquisition, or Renovation: Properties that have been recently constructed, acquired, or renovated are more likely to benefit from a cost segregation study. This is because the study can identify and accelerate the depreciation of newly installed assets.
• Taxable Income: Investors with higher taxable income can often take advantage of accelerated depreciation to reduce their current tax liability. However, depreciation taken for rental activities creates a passive loss and can most often only offset other passive taxable income. Any excess losses can be carried forward to offset future passive income. This passive loss limitation may not apply if you qualify as a real estate professional. For more information on the real estate professional rules, read the article "Maximizing Savings with Real Estate Professional Tax Status."
• High Percentage of Personal Property: Properties with a significant amount of personal property, such as furnishings, fixtures, and equipment, are better candidates. Personal property often has a shorter recovery period than real property, leading to accelerated depreciation.
• Use of Costly Building Systems: Properties with expensive building systems, such as HVAC (heating, ventilation, and air conditioning), electrical, or plumbing systems, may benefit from cost segregation. Breaking down the costs of these systems can result in shorter recovery periods and increased depreciation deductions.
• Energy-Efficient Features: Properties with energy-efficient features, such as lighting, HVAC systems, or other energy-saving technologies, may qualify for specific tax incentives and accelerated depreciation through cost segregation.
  
  

When is the Best Time to Conduct a Cost Segregation Study?

Property owners should consider a cost segregation study during a property's design or acquisition phase. However, performing a study on existing properties can also be beneficial in capturing missed depreciation deductions from prior years. Property previously placed into service in Year 1 can be changed on a tax return in future years by reporting depreciation changes on Form 3115, Application for Change in Accounting Method. This allows the change in depreciation to be realized in the tax year when the cost segregation study is completed.

One important note is that you must elect to take bonus depreciation or opt out of it. If an election was made to opt out of bonus depreciation in a prior year, you cannot undo the election in a future year. Fortunately, depreciation can still be taken annually over the shortened life assigned to different asset classes per the study.

Conclusion

A cost segregation study is a powerful tool for optimizing tax benefits and improving overall financial performance. When used correctly as a strategic tax planning tool, these studies can reduce your income tax through the acceleration of depreciation on real estate property. Lower income tax expense results in increased cash flow available, providing a faster turnaround for real estate investors to plan for and purchase their next real estate project. It's important for real estate investors to consult with tax professionals and cost segregation specialists to assess their specific situation and determine whether a cost segregation study is a suitable strategy for optimizing tax benefits. Professionals will also help expedite the process and maintain tax compliance when navigating cost segregation studies.

About the Author

Geoffrey Kaufman, CPA, MBA

Geoff joined Trout CPA in August 2020. He graduated Summa Cum Laude from Lebanon Valley College's 3+1 Accelerated Bachelor of Science in Accounting and MBA Program. He currently serves on the firm's Construction & Real Estate, Manufacturing & Distribution, and Estate & Trust Practice Groups. As a Senior Associate, Geoff assists with attest services, including financial statement preparation, and provides tax planning and preparation support for individuals and corporations. Additionally, Geoff specializes in helping real estate investors navigate the complexities of their financial and tax obligations. In his free time, Geoff enjoys spending time with family and friends, hiking, going to the beach at Wildwood Crest, and volunteering in the community. He lives in Lancaster County with his wife.