What Is Cost Segregation Study? Process and Benefits
Unlock tax savings and boost your property's ROI. Discover how a cost segregation study accelerates depreciation and enhances cash flow in our latest guide.
According to recent data, capital flows into the U.S. commercial real estate plunged over 50% in the fourth quarter of 2024 to hit the lowest levels since 2012. Prior to this, Lisa Shalett, chief investment officer at Morgan Stanley at Wealth Management, had cautioned in a New York Post report that the commercial property owners were facing a “huge hurdle,” exacerbated by high lending interest rates and post-pandemic vacancies.
While the challenges will likely subside with time, landlords must seek new ways to maximize profitability and stay in business. One way to do that is by conducting a cost segregation study to maximize depreciation deductions and lower the overall tax burden. But how does a cost segregation study work? And can you do a cost segregation study yourself? Find out in this elaborate guide.
What is a Cost Segregation Study?
A comprehensive analysis of a real estate property that identifies building components which can be reclassified to shorter depreciable lifespans. This process allows owners or investors to accelerate depreciation deductions, reduce taxable income, and improve cash flow.
The Process
Feasibility Analysis
Evaluate the property’s type, cost, age, and potential tax benefits to determine if a study is worthwhile.
Engineering Review
Conduct a thorough analysis to identify and classify building components into asset groups (e.g., 5-year, 7-year, or 15-year depreciation schedules).
Report & Implementation
Compile a detailed report and work with tax professionals to implement the accelerated depreciation deductions.
Key Benefits
Tax Savings
Accelerated depreciation lets you claim deductions much sooner than standard 27.5 or 39-year schedules, lowering current tax liabilities.
Improved Cash Flow
Immediate tax relief increases available capital for reinvestment, property improvements, or other business initiatives.
Compliance & Documentation
Detailed engineering reports provide a solid audit trail and ensure adherence to IRS guidelines, reducing audit risk.
Who Should Consider a Cost Segregation Study?
Ideal for owners and investors of commercial properties, industrial facilities, and residential rental properties—especially those involved in new acquisitions, renovations, or properties that have not previously undergone a study.
Introduction
A cost segregation study is a comprehensive analysis of a real estate property that identifies building components that can be reclassified to shorter depreciable lifespans. This allows owners or investors to accelerate depreciation deductions for these components and save money on deferred taxes.
Knowing how to perform a cost segregation study is important because it presents various financial benefits that can stimulate cash flow for years, especially if you own the property long-term. At the same time, accelerated depreciation on certain building components can bolster the return on investment (ROI) for the property owner by shrinking the overall cost of ownership.
How Does a Cost Segregation Study Work?
Now that you understand the cost segregation study definition from a layman’s perspective, how does it work? Before we look into the detailed step-by-step process, let’s explore two key areas that constitute the study:
Asset Identification and Classification
The first aspect of a cost segregation study is identifying and classifying building components that qualify for accelerated depreciation deductions over five, seven or 15 years. While doing this, it’s essential to distinguish between personal and real property, especially if you’re going to maximize your benefits with this tax strategy.
While personal property includes temporary assets affixed to the building that can be moved without causing significant damages, real property is basically land and other permanent components that make up the building’s structure. Personal property assets include furniture, carpeting, fixtures and certain plumbing and electrical parts with a five-year lifespan.
You can also claim accelerated depreciation deductions on specialized machinery and office equipment attached to a seven-year-old property or land improvements, such as landscaping and sidewalks, which are typically depreciated over 15 years.
Depreciation Acceleration
After identifying and reclassifying the building components, you’ll need to reallocate their costs to shorter depreciation periods to start claiming deductions in the early years of ownership. As noted earlier, the depreciation schedules can be five, seven, or 15 years, depending on the type of asset and how fast you want to take advantage of the eligible write-offs.
By allocating a certain percentage (20-40%) of these costs to accelerated depreciation schedules, you can lower your taxable income to benefit from immediate tax savings or improve cash flow in the long haul if you claim eligible deductions regularly.
A complementary tax strategy to cost segregation is bonus depreciation, which allows property owners to immediately expense a significant portion of qualified assets. Understanding how bonus depreciation phases out in upcoming years is crucial for effective tax planning. Learn more about how it works in our guide Bonus Depreciation and the Phaseout.
Benefits of Conducting a Cost Segregation Study
Understanding what is a cost segregation study and how to apply it to your real estate property can result in various short-term and long-term benefits, including:
1. Tax Savings
Reclassifying building components into short-lived depreciable assets allows property owners to seize depreciation opportunities sooner rather than waiting for the standard 27.5 or 39-year period. With this approach, you can lower your current tax liabilities, thereby reducing the amount of tax owed to the IRS in the long run.
Cost segregation is just one of many powerful tax planning tools available to business owners. Implementing a proactive tax strategy can lead to significant savings and financial flexibility. Discover six key tax planning benefits in our detailed guide here.
2. Improved Cash Flow
In addition to providing immediate tax-saving benefits, professionals who know how to get a cost segregation study done can help you improve cash flow, giving you financial relief to channel the extra capital to other business initiatives and investment opportunities. For instance, these tax savings can be used to improve the building’s condition and bolster its value, cover operating expenses, or pay off debt.
3. Compliance and Documentation
Experts who can do a cost segregation study usually prepare and maintain meticulous records of the investment property, allowing you to remain compliant with IRS guidelines. Besides safeguarding your reputation within financial and regulatory circles, compliance can save you from unnecessary audits and disputes, which can trigger unintended losses.
At the same time, thorough reporting of engineering documents, cost breakdowns, and any supportive evidence for building components reclassification can support the findings of the underlying cost segregation study and provide a comprehensive audit trail if regulators want to conduct a review.
Have Questions about Cost Segregation Study?
The Process of Conducting a Cost Segregation Study
The first question that lingers in the mind when you think about maximizing tax benefits on your real estate property is can I do my won cost segregation study? Well, while it might be tempting to DIY it, it’s advisable to consult with professionals who can ensure that the process is accurate and compliant with IRS guidelines to maximize its benefits.
Experts who know how to do a cost segregation study usually follow these three steps:
Step 1: Feasibility Analysis
The first step involves determining whether the underlying real estate property is a suitable candidate for a cost segregation study and if the process will result in immediate and long-term benefits for the owner. After reviewing the property type, age, size, and use, the cost segregation study expert will analyze its purchasing price, as well as construction and renovation costs to establish whether the potentially saved taxes can offset the cost of the process.Step 2: Detailed Engineering Review
If the tax savings are enough to cover the study’s cost and benefit the owner, the expert will proceed to a thorough engineering review. At this stage, the professional will review each component of the building and create a detailed breakdown of their costs before reclassifying them into shorter depreciation periods.Step 3: Report Generation and Implementation
The last step involves compiling the study’s findings and generating a detailed report that will be used as a supporting document to claim the accelerated depreciation deductions when filing for tax returns. This document must be reviewed by a professional tax advisor to ensure it is consistent with all IRS provisions regarding cost segregation studies.Effective financial management goes beyond cost segregation—having an outsourced CFO can help align tax strategies with broader business goals. If you’re looking for expert financial guidance, explore our outsourced CFO services.
Who Should Consider a Cost Segregation Study?
To this point, you have wrapped your head around the tax-saving opportunities offered by a cost segregation study and you’re ready to proceed with your own study. But the billion-dollar question is when does cost segregation make sense? For the uninitiated, this tax planning strategy can be beneficial depending on the following factors:
Property Types
While cost segregation studies can be applied to various property types, certain real estate buildings could benefit more from the tax-saving strategy, thanks to their complexity and the nature of attached assets. These include commercial properties, such as business complexes, industrial facilities, and warehouses, which typically have many building components that can be reclassified during the study.
For those in the construction industry, proper bookkeeping practices are essential to tracking project costs, depreciation, and tax deductions. Explore key financial management tips in our article Bookkeeping for construction companies.
Residential rental property owners also benefit from a cost segregation study by reclassifying eligible assets, such as outdoor renovations, built-in appliances, carpeting, and certain types of lighting fixtures.
For property owners and investors, understanding real estate tax strategies is key to maximizing returns and cash flow. Our specialized real estate industry services can help you navigate tax planning, accounting, and compliance
Ownership Scenarios
This tax-saving strategy can also be bneficial in certain property ownership scenarios, especially if the underlying owner understands what’s a cost segregation study and how to go about it. These scenarios include:
A. New Property Acquisitions
Taxpayers who have just acquired a new real estate property can conduct a cost segregation study to start claiming eligible depreciation deductions as soon as possible. The study can be particularly beneficial in cases where the acquisition cost is relatively high or extensive land improvements have been done.
For real estate investors in partnerships, it’s also important to consider how depreciation deductions affect partnership losses and basis limitations. Learn more about navigating these tax complexities in our guide Partnership losses in excess of basis.
B. Renovations and Improvements
Real estate owners often conduct renovations and improvements to increase the value and curb appeal of their properties. If you’ve recently done this, you can leverage the study to reclassify the costs of HVAC systems, plumbing components, or other upgrades eligible for appreciated depreciation.
C. Existing Properties Without Prior Studies
You can conduct a “look-back” study and benefit from accelerated depreciation deductions if you own a property that has never been subjected to a cost segregation study. However, you’ll need to fill in Form 3115 to complete the Change in Accounting process to catch up on the missed deductions.
Potential Risks and Consideration
Although a cost segregation study can be beneficial in many ways, it’s worth noting that it could present far-reaching risks that can downplay the strategy’s value. For instance, you might face the challenge of a depreciation recapture upon selling the property, after which the IRS will tax a portion of the gains attributable to the tax-saving strategy during your ownership.
Fortunately, you can mitigate this challenge by leveraging a 1031 exchange to reinvest the sale’s proceeds into another property, thereby deferring the underlying recapture taxes. A 1031 exchange is a valuable tool for deferring capital gains taxes when selling an investment property. Understanding how to properly execute this strategy can help maximize tax efficiency. Read more about 1031 exchange services.
Alternatively, you can hold the property for a long time to avoid recapturing taxes altogether or consult with an advisor to include unexpected tax expenses in your long-term financial strategies.
A well-executed exit strategy is essential to maximizing real estate investment returns. Whether through a 1031 exchange or other tax-efficient methods, understanding the best approach can make a significant difference. Read more about tax-efficient real estate exit strategies here.
In addition to recapture taxes, the cost of cost segregation study can also outweigh the benefits of the process, leaving you with a negative balance sheet. With this in mind, it’s imperative to evaluate the study’s upfront cost against the potential tax savings to gauge whether it makes sense. Factors that may affect the overall cost of the study include the property’s size and complexity, the service provider’s rate and the level of detail needed to accurately reclassify the building components.
Conclusion
Knowing how to do a cost segregation study and leveraging the findings to claim accelerated depreciation deductions can help property owners save money and improve cash flow to reinvest in other profitable business initiatives. However, the study might not be as simple as it sounds, especially on expansive properties, imploring owners to work with professionals. By working with a reputable service provider, you can ensure the study is accurate and compliant with IRS guidelines to maximize its potential benefits without risking an audit.
If you’re considering a cost segregation study, working with a professional service provider ensures accuracy, IRS compliance, and maximum tax benefits. Our team specializes in helping property owners optimize their tax strategies. Learn more about our cost segregation services here.
