Are you wondering what cost segregation is and how it can help you lower your taxes? In this blog, we define this strategy and talk about how it can be applied, who can benefit from a cost segregation study, and how the latest tax reforms make it an even more powerful tool for commercial real estate (CREO) owners and investors.
When used correctly, cost segregation can potentially increase your cash flow while reducing tax liabilities and uncovering missed deductions. And because of the changes made in the Tax Cuts and Jobs Act (TCJA) of 2017, its benefits have become even more favorable for the CRE industry. This strategic tax planning tool can potentially shelter taxable income by expensing or ‘depreciating’ particular commercial property components faster than usual.
But First, What is Depreciation?
Depreciation of an asset means to deduct the loss of its value (due to wear and tear and average use) over a certain period. Commercial real estate properties have depreciated over 39 years. Most CRE assets used straight-line depreciation, expensing its value as a whole over those 39 years.
Cost segregation provides CRE owners and investors the opportunity to depreciate the asset faster and use bonus depreciation for even more tax savings.
Cost Segregation Defined
In sort, cost segregation can be a handy tax reduction strategy for CRE investors who have purchased or built commercial land or real property. By having a segregation analysis or cost segregation study completed on their property, they can potentially reduce their taxable income.
Cost segregation essentially converts a non-residential real property (1250 property) that typically will depreciate over 39 years into a tangible personal property (1245 property) that depreciated over just 27.5 years. The accelerated depreciation applies to the particular exterior and interior components of the CRE asset.
The result? The CRE investors’ income tax rate could be lowered because they can write off portions of their CRE assets faster than what is allowed by traditional straight depreciation, thereby increasing their profitability and cash flow.
Cost segregation done right can be a powerful tax planning tool for CRE investors and owners who want to improve their tax positions. A study assesses a CRE asset and identifies costs that can be classified as ‘personal property.’ By separating the personal property from the commercial building itself, a segregation analysis can reclassify components that would usually be depreciated over 39 years to asset groups that can be expensed at a more accelerated pace—and in some cases, depreciated immediately.
The tax reforms in the TCJA of 2017 make cost segregation an even more powerful tool. Two changes were made in terms of bonus depreciation:
(1) The bonus percentage was increased to 100% through the tax year 2022, and
(2) Used property was made eligible for bonus treatment.
Before these changes, there was an expectation that bonus depreciation would only be 50% and only new properties were qualified.
Because of these reforms, doing a cost segregation analysis can now have an even more substantial impact on CRE Investors and owners. Assets removed from the ‘real property’ category and transferred to ‘personal property’ may now be bonus-depreciation eligible and can potentially be depreciated immediately in the first year.
To illustrate, let’s say that a taxpayer buys a commercial building for $10,000,000. After having a cost segregation study done on it, that owner can potentially reclassify 10% of that $10,000,000 to the personal property’ category.
Assigning a much shorter depreciable life to these assets can enable that investor to write off 10%–in this case, one million dollars—of the $10,000,000 purchase price in the first year. A taxpayer whose marginal tax rate is 25% can save 2.5% of the purchase price of $250,000 in taxes on year one.
How do I start?
To take advantage of the cost segregation strategy, you need to have a cost segregation study (also called a segregation analysis) on your commercial property.
Cost segregation studies have to be completed by professionals who can provide formal cost segregation analyses. These professionals have experience in tax accounting, construction, architecture, and engineering. They may also hold the designation of a Certified Cost Segregation Professional (CCSP).
The study separates qualified items that would otherwise be categorized as 1250 property, including the following:
- Storage tanks
- Process piping
- Phone and computer systems
- Special plumbing
- Ventilation systems
- Lighting fixtures
- Concrete slab floors
- Millwork and partitions
- Carpeting and wall coverings
- Electrical systems
- Specialized kitchen equipment
Do note that qualified assets vary depending on the property and project type. There is some debate on how exactly to determine what qualifies as 1245 assets. This is why it’s crucial to work with professionals who can carry out a proper cost segregation study and audit technique.
How much does it cost to have a cost segregation study done?
A segregation analysis by a professional typically costs anywhere from $10,000 to $15,000. It’s a significant expense, so it doesn’t make sense for all property investors. However, cost segregation studies routinely used by rental property owners and savvy commercial real estate investors with significant business activity and those who would benefit from potentially large reductions in their income tax rates.
If your CRE business currently doesn’t generate a high-enough income or if the resulting tax savings that the study would provide are not likely to exceed the analysis’s cost, don’t bother. However, if the expenses involved in having your property analyzed are but a small portion of your property’s income, this tax reduction tool is certainly worth looking at.
When is the right time to do a cost segregation study?
Commercial real estate experts recommend completing a segregation analysis immediately after purchasing, constructing, or remodeling a property. It can also be done within the first year for maximum tax benefits.
Should you do it?
You can potentially save hundreds of thousands of dollars in taxes depending on your commercial property—primarily because of the 100% bonus depreciation currently in effect. Whether or not cost segregation is the right move for you depends on your specific circumstances.
Talk to a qualified professional—such as an accountant whose focus is commercial real estate—for guidance. Do also note that cost segregation is a Federal tax law; some states don’t allow this strategy to be used. Check your local laws.
If you decide to have the study done, it’s also essential to work with professionals who can conduct it in accordance with the audit techniques and current standards according to the IRS. These professionals may include veteran engineers, top-notch CPA firms, and holders of the CCSP designation.
Overall, cost segregation is worth the effort for commercial real estate investors with enough business activity to the comfort of the cover the costs and for whom a segregation analysis can mean significant tax savings. Prudent investors to take advantage of this strategy can potentially lock in many years of tax-free returns—if not decades.
Accelerating depreciation deductions can lower your taxes due and taxable income. As a result, you may see increases in your business’ cash flow. This will allow you to reinvest those savings to continue growing your commercial real estate portfolio.