Could a cost segregation study help you save on taxes?

If you’re a building owner wanting to improve your cash flow and financial position, you could consider a cost segregation (seg) study. This study analyzes a building’s components to separate and classify them into shorter depreciation lives.   

Under standard tax rules, buildings must depreciate over 27.5 years for residential rentals and 39 years for commercial buildings. A cost segregation study classifies specific components of the building, such as electrical and plumbing systems, as personal property, which can depreciate over five, seven, or fifteen years. The owner can claim a greater portion of the building’s cost as a tax deduction in the early years of ownership rather than spreading it out over 27.5 or 39 years. 

A cost seg study also leverages the time value of money principle to improve cash flow. According to this principle, a dollar today is worth more than a dollar in the future. By accelerating the depreciation expense, the building owner can take advantage of the present value of money rather than waiting 27.5 or 39 years to claim the total value of the building as a tax deduction. With more cash on hand, real estate investors can acquire additional properties.  

To illustrate the time value of money as it relates to accelerated depreciation in real estate, let’s consider a building with a total cost of $1,000,000. Here’s how much depreciation could be claimed each year: 

• Over five years: $200,000 annually as a tax deduction 
• Over seven years: $142,857 annually as a tax deduction 
• Over 15 years: $94,684 annually as a tax deduction 
• Over 27.5 years: $36,363 annually as a tax deduction 
• Over 39 years: $25,000 annually as a tax deduction 

In the above example, business components have been classified simultaneously. In reality, the building will have business components within multiple depreciation periods. 

You can conduct a cost segregation study at any point, whether the building was purchased, constructed, or has been in use for some time. However, it’s more efficient to perform a study on buildings under construction or newly built. You can use the schedule of values from the contract file, making the process more accurate and cost-effective. 

A cost seg study typically begins with a walk-through of the building, during which the cost segregation consultant will identify and document all the building’s components, including electrical, plumbing, HVAC, and other systems. They’ll also determine the costs of each component and the building’s overall construction costs. With this information, the consultant will classify the various components of the building as real property or personal property, depending on their expected useful lives.   

The consultant will provide the building owner with a detailed report that includes the costs of each component, as well as the accelerated depreciation schedule usable for tax purposes. The building owner can then work with their CPA to file the necessary tax forms and claim the additional depreciation. The CPA will report the study results by completing Section 481(a) of IRS Form 3115 to report the additional depreciation claimed.  

Be sure to work with your CPA to choose a consultant; they can ask pertinent questions, help you determine if it makes financial sense to pay for the study, and ensure a high-quality final report. 

Based on research and experience, below are a few best practices when considering a cost segregation study: 

• Work with your CPA to determine if a cost segregation study is right for you. For instance, if passive losses are carried forward, then you don’t need a cost seg study because it only increases these losses. Also, have your CPA evaluate the potential tax savings of doing a study.  
• Use an engineer or other qualified professional to conduct the study—your CPA can’t do it alone. This professional should understand construction and a schedule of values; you may consider a contractor who builds and renovates residential buildings or constructs and retrofits commercial buildings. 
• Understand that a cost segregation study is required to break out your building’s components; you can’t alter your depreciation schedule and “randomly” assign values to various components. 
• Evaluate the professional or consulting firm performing the cost segregation study. Ask for an example of their final report and get multiple fee quotes. 
• Compare the example of the final report to the fee quote. Avoid using the lowest bidder because, as with everything in this world, you get what you pay for. 
• Ask questions—lots of them. Find another candidate if a potential consultant makes you feel like asking questions is wrong. 

A cost segregation study can accelerate depreciation expense, improve cash flow, and increase your overall financial position, but not in every situation. Aldrich’s team of experts can help you determine if a cost segregation study is right for your business. If you have questions or want to learn more, let’s talk.