Many investors are aware that commercial real estate is a highly tax advantaged asset class. That’s why so many of the nation’s most successful investors (e.g., Warren Buffett, Sam Zell, Steve Jobs) have real estate in their portfolios.
Depreciation is arguably the most significant tax benefit. Properties can be depreciated over a certain period of time, which is then used as a write-off against the taxable income the property generates. However, rather than utilizing traditional, “straight-line” depreciation, investors can utilize what’s known as cost segregation to maximize their profits in the early years of property ownership.
Here is your full guide to cost segregation, including how to conduct cost segregation studies on your commercial property.
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What is Cost Segregation?
Cost segregation is a tax strategy used in commercial real estate to accelerate depreciation deductions and reduce the overall tax burden. It involves the process of identifying and reclassifying specific components or assets of a commercial property in order to allocate their costs to shorter depreciable life classes.
Typically, when a commercial property is purchased or constructed, the IRS requires the property owner to depreciate its value over a specific period (usually 27.5 years for residential rental properties and 39 years for non-residential properties) for tax purposes. However, many assets within the property, such as certain fixtures, improvements, or equipment, have shorter depreciable lives.
Cost segregation allows property owners to identify these assets and categorize them separately so they can be depreciated over their respective shorter lifespans (usually 5, 7, or 15 years). By doing so, the property owner can front-load the depreciation deductions, which results in significant tax savings in the early years of ownership.
How Cost Segregation Saves Owners Money
Commercial real estate owners can save money by using cost segregation primarily through increased cash flow and reduced tax liabilities. Here's how it works:
The primary benefit of cost segregation is the ability to accelerate the depreciation of certain assets within the property. As mentioned earlier, while commercial properties typically have a long depreciation period (e.g., 39 years), cost segregation allows owners to identify shorter-lived assets (e.g., 5, 7, or 15 years) and depreciate them separately. By front-loading the depreciation, property owners can claim larger deductions in the early years of ownership, which leads to reduced taxable income and lower tax payments.
Increased Cash Flow:
By reducing their tax liabilities through accelerated depreciation, property owners can free up more cash flow in the short term. This additional cash can be reinvested into the property, used for other business purposes, or for personal investments.
Cost segregation effectively defers taxes to future years. While the tax savings are realized early on due to accelerated depreciation, property owners need to be aware that they will have smaller depreciation deductions in later years. Nevertheless, deferring taxes can be advantageous, as money saved on taxes in the present can be invested and generate additional returns until the tax liability is due in the future.
Potential Tax Credits:
In some cases, cost segregation can also lead to the identification of tax credits or other incentives related to energy-efficient components or improvements within the property. These credits can further reduce the overall tax burden.
Improved Property Valuation:
Properly executed cost segregation studies can provide a more accurate breakdown of the property's assets and their values. This can lead to a more precise valuation of the property, which may have benefits in terms of insurance coverage, financing, and potential future sales.
Even if a property has been owned for several years, cost segregation can still be beneficial. A "look-back" study can be conducted to identify assets that were not previously classified, allowing the property owner to claim missed depreciation deductions and potentially obtain tax refunds for prior years.
The Ideal Properties for Cost Segregation
There are some properties that benefit from cost segregation more than others. The ideal properties for cost segregation are those that have a significant number of features that have shorter depreciable lives. These types of properties are more likely to benefit from cost segregation, as it allows for the acceleration of depreciation deductions and provides greater tax savings in the early years of ownership.
Here are a few examples of properties that are usually ideal for cost segregation:
- Newly Constructed Buildings: Commercial properties that have been recently constructed are excellent candidates for cost segregation. During construction, there may be a detailed breakdown of costs, making it easier to allocate expenses to specific assets.
- Renovated or Recently Remodeled Buildings: Properties that have undergone significant renovations or remodeling may have components that qualify for shorter depreciable lives. Cost segregation can identify these assets and allow for accelerated depreciation.
- Hotels and Restaurants: Hospitality businesses often have a substantial amount of personal property, such as furniture, fixtures, and equipment, which may qualify for shorter depreciation periods.
- Medical Facilities: Medical buildings often contain specialized equipment and fixtures that can be classified separately for accelerated depreciation.
- Retail Stores: Retail properties typically have various fixtures, display units, and signage that can be segregated for shorter depreciable lives.
- Manufacturing Facilities: Manufacturing plants and facilities often have a mix of machinery, equipment, and other assets that can benefit from cost segregation.
- Warehouse and Distribution Centers: Properties used for warehousing or distribution may have specific assets that qualify for shorter depreciation periods.
- Office Buildings: Office properties may contain components such as carpets, lighting, partitions, and communication systems that can be reclassified for faster depreciation.
While cost segregation can be advantageous for these types of properties, not every property will experience the same level of benefit. The decision to conduct a cost segregation study should be made after considering the specific characteristics of the property.
Cost Segregation Case Study
Let’s use a simple example to show how impactful cost segregation can be for commercial real estate investors.
The sample property is a retail store purchased for $5 million. Without cost segregation, the entire property would be depreciated over 39 years (the standard depreciation period for non-residential commercial properties).
A cost segregation firm is engaged to conduct a study on the retail store. The study involved a detailed property inspection, data analysis, and asset classification to identify assets that could be reclassified for accelerated depreciation.
The cost segregation identified the following assets and their respective depreciation classes:
- Personal Property – 7 Year Depreciation
Fixtures and displays, shelving units, signage and branding elements, security systems, point-of-sale (POS) systems, decorative elements.
- Land Improvements – 15 Year Depreciation
Landscaping and outdoor improvements, parking lot lighting.
- Building Components – 39 Year Depreciation
Structural elements such as the building’s foundation, walls, and roof
Traditional Depreciation: 39-Year Straight-Line Method:
Annual Depreciation Expense = $5,000,000 / 39 years = $128,205
Cost Segregation Depreciation (Accelerated Method):
- Personal Property (7-year depreciation): $1,500,000
- Land Improvements (15-year depreciation): $500,000
- Building Components (39-year depreciation): $3,000,000
Annual depreciation expense for Personal Property and Land Improvements = ($1,500,000 + $500,000) / 22 years = $95,455
Total Annual Depreciation Expense:
Traditional Depreciation: $128,205
Cost Segregation Depreciation: $95,455
Assuming a corporate tax rate of 21%, the tax savings in the first year due to cost segregation would be:
Tax Savings = (Traditional Depreciation - Cost Segregation Depreciation) * Tax Rate Tax Savings = ($128,205 - $95,455) * 0.21 Tax Savings = $6,885
In this example, the cost segregation study resulted in an annual tax savings of $6,885 for the retail store owner. Over the first five years, the total tax savings would amount to approximately $34,425.
Who Conducts a Cost Segregation Study
Cost segregation studies should always be conducted by experienced professionals to ensure compliance with IRS guidelines and regulations. Cost segregation studies are typically conducted by firms that specialize in engineering, construction, and tax-related services. The main types of firms that do cost segregation studies are as follows:
- Cost Segregation Firms:
These are specialized firms that focus primarily on providing cost segregation services to commercial property owners. They have a team of engineers, architects, and tax specialists who work together to identify and classify assets, perform engineering analyses, and calculate tax savings for their clients.
- Engineering Firms:
Some engineering firms offer cost segregation as one of their services. They typically have the expertise to assess the structural components and other building systems of commercial properties to determine the appropriate asset classifications for depreciation purposes.
- Tax Advisory Firms:
Many tax advisory or accounting firms offer cost segregation studies as part of their broader range of tax services. These firms combine their tax knowledge with engineering expertise or collaborate with engineering firms to conduct the cost segregation study.
- Construction Cost Consultants:
These firms specialize in evaluating construction costs and estimating the value of assets within a property. They can be engaged to perform a cost segregation study, especially when the property has undergone recent renovations, improvements, or new construction.
- Real Estate Consulting Firms:
Some real estate consulting firms may have a division or team that provides cost segregation services to their clients. They may offer this service as part of their comprehensive real estate advisory services.
- Large Accounting Firms:
Big accounting firms may have dedicated departments or teams that specialize in cost segregation studies. These firms often collaborate with engineering or construction experts to provide comprehensive cost segregation services.
When selecting a firm to conduct a cost segregation study, it's crucial for property owners to consider the firm's experience, reputation, and qualifications. Look for firms with a track record of successfully completed cost segregation studies and positive client testimonials. Additionally, ensure that the firm's professionals have the necessary certifications and expertise in engineering, construction, and tax matters to conduct a thorough and accurate study.
How to Conduct a Cost Segregation Study
Conducting a cost segregation study requires a systematic approach and the involvement of qualified professionals, such as engineers, architects, and tax specialists. Here are the typical steps involved in the cost segregation study process:
- Engage a Qualified Firm:
The property owner should first identify and engage a reputable firm with experience in cost segregation studies. Look for firms with expertise in engineering, construction, and tax law to ensure a comprehensive and accurate study.
- Conduct a Property Inspection:
The cost segregation team will visit the property to conduct a thorough inspection. They will identify and document all relevant components, assets, and improvements that may qualify for shorter depreciation lives. This includes everything from structural elements to fixtures, electrical systems, plumbing, HVAC systems, and more.
- Classification of Assets:
Based on the inspection, the team will categorize each asset into the appropriate depreciation class according to IRS guidelines. These classes include 5, 7, 15, 27.5, and 39 years, depending on the asset's useful life.
- Cost Allocation:
The next step is to determine the cost of each identified asset. This involves analyzing construction records, invoices, and other relevant documents to accurately allocate the purchase or construction costs to each asset category.
- Engineering Analysis:
For certain components or assets, engineering analysis may be required to establish their actual useful life and eligibility for accelerated depreciation.
- Financial Analysis:
The cost segregation team will then perform a financial analysis, taking into account the applicable tax laws and regulations, to calculate the potential tax savings resulting from the reclassification of assets.
- Generate Report:
Once all the data is collected and analyzed, the cost segregation firm will prepare a detailed report outlining the findings and calculations. This report will serve as the documentation for the cost segregation study and will be crucial in case of an IRS audit.
- Final Tax Filing:
The property owner can then use the findings from the cost segregation study to file amended tax returns or adjust future tax filings to reflect the accelerated depreciation of assets.
As noted above, it is essential to collaborate closely with the cost segregation firm throughout the process to ensure accuracy and compliance with IRS regulations.
How Long Does a Cost Segregation Study Take?
The duration of a cost segregation study can vary depending on the size and complexity of the commercial property being analyzed, as well as the efficiency of the team conducting the study. On average, a cost segregation study may take anywhere from a few weeks to several months to complete.
For example, the initial consultation might only take a day, but the follow-up property inspection might take a few days to a few weeks, depending on the size and complexity of the property. The data analysis will then generally take a few weeks, followed by the engineering and financial analysis, which can also take a few weeks. The final report will generally take at least another week to complete.
While it may seem like a long process, owners and investors should be careful to follow each step closely. Rushing the process can lead to errors or oversights that may impact accuracy and/or IRS compliance.
The Cost of Cost Segregation
The costs associated with completing a cost segregation study can vary widely depending on several factors, such as the size and complexity of the commercial property, the number of assets being analyzed at that time, the location of the property, and the level of detail required.
Most owners can expect a cost segregation study to cost anywhere between $5,000 to $30,000 or more.
Smaller properties with fewer assets and simpler structures will generally have a lower cost for the study. On the other hand, larger properties with a more significant number of assets, complex building features, or multiple buildings on the same site may require more extensive inspections and analysis, which can result in higher costs.
Owners should obtain quotes from several reputable cost segregation firms and carefully review the scope of services provided in each proposal. Cheaper options may not always offer the same level of detail or accuracy, and it's crucial to prioritize the quality and expertise of the firm conducting the study.
Moreover, while the initial cost of the study may seem significant, it's essential to consider the potential tax savings and increased cash flow that can result from accelerated depreciation. A well-executed cost segregation study can often provide significant benefits that outweigh the initial investment in the study.
Pros and Cons of Cost Segregation
Cost segregation can offer significant benefits for commercial real estate investors, but there are some drawbacks to consider. Below is a brief overview of the pros and cost of cost segregation.
Pros of Cost Segregation:
- Increased Cash Flow:
Cost segregation allows property owners to accelerate depreciation deductions, leading to higher tax savings in the early years of ownership. This increased cash flow can be reinvested into the property, used for business expansion, or for other investments.
- Reduced Tax Liability:
By reclassifying certain assets and depreciating them over shorter periods, property owners can lower their taxable income, resulting in reduced tax liabilities.
- Faster ROI:
Cost segregation can lead to a faster return on investment for the property, as tax savings are realized sooner, improving overall property profitability.
- Retroactive Benefits:
Property owners can conduct a "look-back" study and claim missed depreciation deductions for previous years, potentially obtaining tax refunds.
- Improved Property Valuation:
Accurately identifying and categorizing assets through cost segregation can lead to a more precise property valuation, which may have benefits for insurance coverage, financing, and potential future sales.
- Energy Efficiency Incentives:
Cost segregation can uncover assets or improvements that qualify for tax credits or other incentives related to energy-efficient upgrades.
Cons of Cost Segregation:
- Upfront Cost:
The cost of conducting a cost segregation study can be significant, especially for larger and more complex properties. As noted above, cost segregation studies can range from $5,000 to $30,000 or more. This upfront expense may deter some property owners from pursuing the study.
- Time and Effort:
A thorough cost segregation study requires time and effort to conduct property inspections, analyze data, and prepare the final report. Property owners and their teams must be prepared to dedicate resources to the process.
- Future Tax Implications:
While cost segregation provides significant tax benefits in the short term, it may result in smaller depreciation deductions in later years. Property owners need to plan for potential tax implications in the long run.
- Increased IRS Scrutiny:
Aggressive or improperly conducted cost segregation studies can draw attention from the IRS. Property owners must ensure that the study adheres to IRS guidelines and regulations to avoid any potential issues during audits.
In general, the benefits of cost segregation will prove to be especially attractive to commercial property owners looking to improve cash flow and reduce their tax liability. That said, it's essential to weigh the potential benefits against the upfront cost and long-term implications. Engaging experienced professionals and conducting a careful cost-benefit analysis can help property owners make informed decisions about whether cost segregation is the right option for their specific situation.