Many owners of income-producing real estate are unaware that they can maximize the tax savings on their investments with an IRS-approved project called a cost segregation study.
What is Cost Segregation?
Cost Segregation is a strategic tax-planning tool or a tax deferral strategy that allows an owner of a building to identify assets within a building and accelerate the depreciation of certain parts of the building or land over a shorter period of time. It can identify substantial tax-saving opportunities for taxpayers who have constructed, purchased, or renovated a facility. Cost Segregation is the practice of identifying assets and their costs, and classifying those assets for federal tax purposes.
The process combines engineering, construction, and tax expertise to maximize tax deductions for prior and current real estate investments. In a real estate cost segregation study, certain commercial building costs previously classified with a 39-year depreciable life can instead be classified as personal property or land improvements, with a 5, 7, or 15-year rate of depreciation using accelerated methods. Residential buildings, including multi-family buildings, are subject to a 27.5-year life.
An “engineering-based” study allows a building owner to depreciate a new or existing structure in the shortest amount of time permissible under current tax laws.
How to Calculate Depreciation on a Commercial Property
Depreciating investment property can be a significant tax benefit.
Straight Line Depreciation
- Calculate the total cost basis of the commercial property you are depreciating.
- Divide the total value by 39 to get your annual depreciation on a straight-line basis.
- Apply the depreciation to your taxes annually for at least 39 years until the property has been fully depreciated.
Cost Segregation Depreciation of Commercial Property
- Separate the commercial property asset using an engineering report into four separate categories: personal property, land improvements, the building, and land.
- Depreciate the amounts allocated to the personal property over five to seven years using a double-declining method.
- Depreciate the amount allocated to land improvements over 15 years using an accelerated method, such as the 150% declining balance method.
- Depreciate the components of the building separately to take advantage of different tax benefits. For example, although the roof is part of the building, you may be able to depreciate it more quickly separately.
- Allocate the remaining amount to the land category.
How Cost Segregation Works
In a Cost Segregation Study, a property is broken down into smaller components based on its useful lives. This breakdown of components could contain hundreds or even thousands of individual line items depending on the size of the asset.
This is why it is important to make sure all your data is in order before you get started. The goal is to uncover assets that can be depreciated on an accelerated basis, and you can only do this if you have sufficient data on the various components of your commercial real estate property. The study looks at components of a property such as:
1. The building
The building itself (the frame and basic structural components) is only eligible for straight-line depreciation. Noncommercial buildings are eligible for straight-line depreciation over 27.5 years. Commercial buildings are depreciated using a straight-line method over 39 years.
2. Land improvements
Land improvements include sidewalks, landscaping, parking lots, and sprinkler systems. Land improvements have a 15-year accelerated depreciation schedule.
3. Personal property
Tangible personal property such as equipment, flooring, fixtures, window treatments, and computers, to name a few are eligible for an accelerated depreciation schedule of 5 or 7. This aligns with the reality of commercial space, where updates are made on a regular basis to deal with the regular wear and tear on a building.
4. The land
The land is not expensed. Higher profitability, lower tax liability, and increased cash flow are the three primary factors that make cost segregation so important. In addition, lower taxes and increased cash flow mean plans for the business can be crystallized and implemented more easily. Cost segregation is, therefore, part of the bedrock of success for real estate investors and developers.
Who can benefit from cost segregation?
Cost segregation is most beneficial for building owners and investors with properties exceeding $500,000. A cost segregation study can be conducted at any time during the life of a building, whether it is an acquisition, built from the ground up, or renovated.
The best time to conduct a cost segregation study is in the year the building is acquired, constructed, or remodeled. However, the greatest benefits occur in the year the property was put into service. However, you can have a look-back study done any time afterward and claim the resulting write-offs without amending prior-year tax returns. Or you can do a look-back study for a property that was placed in service going back as far as January 1, 1987.
Cost segregation example
Cost segregation studies offer significant tax savings. Let’s consider this example:
Mandate Hub, a heavy manufacturing company, acquires an existing plant for $10 million on July 1, 2013. If the company were to allocate the entire purchase price to the building, its depreciation deductions would be roughly $256,000 per year ($177,000 in year 1, under IRS tables). Mandate Hub obtains a cost segregation study, which concludes that 35 percent of the purchase price is properly allocable to 39-year property, 15 percent to 15-year property, 45 percent to seven-year property, and five percent to five-year property.
Based on IRS tables, and using the Mandate Hub’s first-year depreciation, deductions are as follows:
| Asset Class | Cost | 1st-year depreciation |
|---|---|---|
| 39 years | $3,500,000 | $61,950 |
| 15 years | $1,500,000 | $75,000 |
| 7 years | $4,500,000 | $643,050 |
| 5 years | $500,000 | $100,000 |
| Total | $10,000,000 | $880,000 |
In this example, a cost segregation study generated an additional $703,000 in depreciation deductions in the first year alone.
CONCLUSION
Cost Segregation studies are one of the most valuable tax strategies available to owners of commercial real estate today. This increasingly popular tax strategy offers facility owners the opportunity to defer taxes, reduce their overall current tax burden, and free up capital by improving their current cash flow. Virtually every taxpayer who owns, constructs, renovates, or acquires a commercial real estate structure stands to benefit from a cost segregation analysis.
As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.
What is Cost Segregation?
Cost Segregation is a strategic tax-planning tool or a tax deferral strategy that allows an owner of a building to identify assets within a building and accelerate the depreciation of certain parts of the building or land over a shorter period of time.
Who can benefit from cost segregation?
How much can I save with cost segregation?
The amount of tax savings you can achieve through cost segregation depends on a variety of factors, including the size of your property, the cost of construction, and your overall tax situation. However, it is not uncommon for investors to save tens or even hundreds of thousands of dollars through cost segregation.
