This article is published by AOA USA and authored by Clifford A. Hockley, CPM, CCIM

Cost segregation studies are a very effective way to generate savings when buying investment property. They should be considered by every real estate investor on every transaction. When optimized, they can increase cash flows, reduce tax liability, and uncover missed deductions.

What is a Cost Segregation Study?

A cost segregation study (CSS) is an engineering/accounting study that dissects the construction costs or purchase price of the property into its component parts and then depreciates the parts of the building, such as the HVAC units or the roof, using shorter depreciation lives.

By segregating personal property and shorter-lived components from the building itself, cost segregation studies reassign costs that would have been depreciated over a 27 ½ or 39-year period to asset groups that will be depreciated at a much shorter period of time such as 5, 7 or 15 years, or perhaps even expensed immediately, due to 100% bonus depreciation opportunities.

Depreciation definition: Tax depreciation is the depreciation that can be listed as an expense on a tax return for a given reporting period under the applicable tax laws. It is used by building owners to reduce the amount of taxable income reported. Depreciation is the gradual charging to expense of a fixed asset’s cost over its useful life. Depreciation is a non-cash expense. The IRS allows 15 years of depreciation for gas stations, 27½ years for apartments and 39 years for commercial buildings. Land is typically not depreciated, just buildings.

What are the Benefits of Cost Segregation?

• Cash Flow: The study generates immediate increase in depreciation and cash flow through accelerated depreciation tax deductions.
• Write Off: The study quantifies a property’s major components and leasehold improvements so they can be written off on a more aggressive depreciation schedule.
• Bonus Depreciation: Performing a cost segregation study will now have a stronger impact. Any assets that are removed from the “real property” bucket and placed in the “personal property” bucket may now be eligible for bonus depreciation and can be immediately expensed in the first year.

Example of Benefits of Cost Segregation Study

A taxpayer purchases a building worth $10 million. After performing a cost segregation study, they can reclassify 10 percent of those costs to be personal property. By assigning these assets a shorter depreciable life, they can apply bonus depreciation and write off $1 million of that $10 million purchase price in year one. A taxpayer with a 25 percent marginal tax rate would save $250,000 in taxes, or 2.5 percent of the purchase price, that first year.

Write Off 100% of Your Real Estate Improvements In 2022 By Using Bonus Depreciation

The 2017 tax reform package made two simple changes that make cost segregation studies very valuable. Those changes are:

• Bonus depreciation allows individuals and businesses to immediately deduct a certain percentage of their asset costs the first year they are placed in service.
• The tax law allowed used property as compared to new property to be eligible for bonus depreciation treatment, and it also increased the bonus depreciation percentage to 100 percent through tax year 2022. Prior to this law change, only new property qualified, and bonus depreciation was expected to be only 50 percent in 2019.

Refinance, 1031 Exchange, Or Sell Your Investment for Cash?

• Question: You need cash and want to refinance your property; do you have to recapture depreciation?
• Answer: You do not since you are not selling the property.
• Question: You are ready to exit your investment. What are your options and how does a cost segregation affect you? Can a cost segregation study create a negative impact for you taxwise?
• Answer: If you sell and choose to use a 1031 exchange, generally, no gain or loss is recognized for taxpayers that exchange business or investment property solely for business or investment property of a like-kind under Sec. 1031.

Recapture of Depreciation

If you sell a property, you may need to reimburse the government, defined as recapture, 25% of the depreciation you have taken. It would be prudent for you to have planned out your sale implications (i.e., taxes) with your CPA and your cost segregation professional long before you sell. The key to recapture of depreciation depends on many variables, such as the details of the allocations within the cost segregation study, how long ago the study was completed and if parts of the property have been written off or discarded.

When you sell a property that has been allocated to 5-year, 7-year, 15-year, and 39-year and buy a new property, the new property should also have a cost segregation study implemented to make sure all is allocated correctly. This will take a sophisticated tax professional to plan out with you.

Typically, no gain or loss is recognized for taxpayers that exchange business or investment property solely for investment property of a like‐kind under IRC §1031; nevertheless, recapture tax may be required even when there is an exchange of real estate, if you have completed a cost segregation study on a property recently purchased. This can be offset if the purchased property has at least as much property allocated to those categories as the relinquished properties (meaning both would have to have studies or at least documentation for what you used accelerated depreciation on). What drives this are existing tenant improvements or major capital expenses whose operating lives may have been shortened by a cost segregation study.

NOTE: Finally, a note of caution: cost segregation studies are not recommended for owners of investment homes that they may decide to move into. After they move in, a large, unexpected tax bill might be incurred.