The Tax Benefits of a Cost Segregation Study

Business and individual taxpayers who own commercial real property or residential rental property have an opportunity to reduce their tax liabilities by conducting a cost segregation study to accelerate the depreciable lives of certain assets

A cost segregation study is a strategy that analyzes the components of a building to identify assets that can be depreciated over shorter periods than standard depreciation schedules. This process allows property owners to reduce their taxable income and increase cash flow by accelerating depreciation deductions.

Cost segregation studies can be especially beneficial when qualified property is placed in service in a year that Bonus Depreciation applies.

In most instances, the entire cost of residential rental property is depreciated over 27.5 years. Commercial buildings, such as offices, retail space, grocery stores, restaurants, warehouses, and manufacturing plants are depreciated using a 39-year schedule.

However, under IRS cost segregation guidelines, a significant portion of a building’s cost can be depreciated over shorter periods. Certain building components may qualify for a reduced recovery period over five or seven years, and qualified improvement property and exterior land improvements may qualify for a reduced recovery period of 15 years.

Conducting a cost segregation study allows property owners to separate building components and fixtures into different categories based on their depreciable lives. Common examples include:

The client purchased a commercial property 10 years ago for $5 million and has been depreciating $4 million ($1 million was allocated to non-depreciable land) on a straight-line basis over 39 years with an annual depreciation deduction of approximately $102,000 for a total accumulated depreciation of $1,020,000. 

A recent Cost Segregation study reveals that 30% of the $4 million as more appropriately allocable to non-structural components with a useful life of 10 years or less which would result in accumulated depreciation deductions of about $1,920,000 (30% of $4 million ($1.2 million) plus $720,000 ($72,000 of annual depreciation on the 39-year assets times 10 years). 

As a result, the client is entitled to an additional $900,000 of “catch-up depreciation” in the year the results of the study are reported.

A cost segregation study begins with a feasibility analysis that reviews the taxpayer’s current position, property details, acquisition or construction costs, and potential tax savings. This is based on examining relevant data such as construction costs and invoices, blueprints, engineering plans, appraisals, property condition reports, and similar information.

From there, qualified engineers or specialists inspect the property to identify and document building components and systems (including their condition and use). Costs are allocated to the components using industry standards and methodologies to ensure defensible IRS compliance.

The findings are then implemented in the property owner’s tax filings. This may involve adjusting current depreciation schedules and, if applicable, amending prior tax returns.

Bonus depreciation legislation influences the value and timing of cost segregation studies significantly by altering the immediate tax benefits property owners can claim.

When bonus depreciation was at 100% (the case between 2018 and 2022), cost segregation studies allow property owners to expense the full value of reclassified assets immediately. This creates substantial upfront tax savings, potentially eliminating taxable income in the first year.

As bonus depreciation phases down (to 40% in 2025), the immediate deduction decreases. However, cost segregation still accelerates depreciation, making even this reduced amount valuable for reducing taxable income.

Under current tax law, bonus depreciation is scheduled to decline to 20% in 2026 and to be phased out completely in 2027.

While specific situations may vary, property owners should monitor legislative developments. The potential restoration of 100% bonus depreciation may make waiting until 2016 more attractive than applying the current lower rates this year or next, but they may need enough time to complete a study in 2025 if rates do not change.

The detailed documentation provided by a cost segregation study can promote compliance with IRS regulations and reduce audit risks. A study can also provide a foundation for future tax planning, such as claiming disposition losses when assets are replaced or repaired.

By leveraging these benefits, property owners can significantly enhance the financial performance of their real estate investments while minimizing their tax burdens.

To learn more about cost segregation studies and how they may apply in your situation, contact us.