How Cost Segregation Studies Can Save Property Owners Thousands

by | Jul 17, 2023

Cost segregation studies, a strategic tool leveraged in federal income tax planning, are increasingly gaining recognition for their ability to bolster near-term cash flow by deferring taxes. For property owners, whether in the commercial or residential sector, this tool provides a mechanism to frontload depreciation deductions and thereby minimize tax liabilities.

At its core, a cost segregation study is an analysis that dissects a property into its various components, each with its respective lifespan. Instead of viewing a building as a single asset with a 27.5- or 39-year lifespan, cost segregation breaks it down into subcomponents such as lighting fixtures, heating and cooling systems, and other elements, each with a five- or 15-year lifespan. This reclassification allows for a larger depreciation deduction, especially in the initial years, which can lead to significant tax savings.

Typically, property owners in the real estate, retail, restaurant, manufacturing, automotive dealerships, and healthcare sectors are among those who can benefit the most from cost segregation studies. These studies are generally applicable to new construction, purchased properties, remodels or expansions, and leasehold improvements. To maximize the benefits, a depreciable basis of at least $1 million or leasehold improvements greater than $300,000 is recommended.

A comprehensive cost segregation study involves several steps, commencing with a feasibility analysis. This first step aims to understand the taxpayer's current tax position and identifies property characteristics that could lead to potential tax savings. Following this, all relevant property information is collected. This can include property condition reports, appraisals, closing purchase documents, vendor invoices, and construction details, among others. 

Next, the property is meticulously analyzed, including an appraisal, examination of construction drawings, and classification of cost information. The process culminates with a detailed report encompassing the study results, the methodology used, photographic evidence, and a list of assets with their value broken down by depreciation class. 

The benefits brought about by cost segregation studies can be substantial. Depending on the property type, the reclassification of real estate assets to a shorter life property can range from 10%-40% of the depreciable cost basis. Moreover, the information obtained from a cost segregation study can often reveal other cost savings opportunities, such as deductions for energy efficiency.

However, cost segregation studies are not without potential drawbacks. When a real estate asset is sold, it may be subject to depreciation recapture at the taxpayer's ordinary income rate. Furthermore, the IRS may disagree with the tax position if not adequately supported, leading to possible penalties. This highlights the importance of having a thorough cost segregation report prepared by a tax professional who specializes in this field.

The cost of a cost segregation study can vary based on factors like property size, type, location, and the complexity of the taxpayer's specific tax considerations. Despite the cost, the potential tax savings and cash flow increase make it a worthwhile investment for many property owners.

In conclusion, cost segregation studies offer a powerful strategy for maximizing deductions and minimizing tax liabilities for property owners. By understanding the process and potential benefits, property owners can make informed decisions and potentially realize significant tax savings.

If you would like more information or want assistance with cost segregation strategies, Freese, Peralez, & Associates are here to help. Give us a call today!