Real Estate Cost Segregation Studies: A Valuable Tax Savings Tool
Whether you are currently constructing a building, have recently purchased one, or even purchased a building years ago, a Cost Segregation Study can give your cashflow an immediate boost. Here’s how.
Although many assets depreciate, they often depreciate at different rates.
Under current tax law, real-estate owners generally allocate the total purchase price of a property into two components: buildings and land. Land does not depreciate. Buildings do—over a period of 27.5 years for residential and 39 years for non-residential.
But it’s not always that simple. There are often components within a property – such as equipment and furniture, or certain improvement projects like drywall replacement – that have shorter depreciable lives than the building itself. While the building depreciates over 27.5 or 39 years, these subcomponents may depreciate over 5, 7, or 15 years.
Why does this matter?
Because, by separating your depreciable assets into subcomponents, you can identify items eligible for accelerated depreciation, allowing you to deduct a larger percentage of those subcomponents in Year 1 (or the year in which you perform a Cost Segregation Study, which we’ll explain in a minute).
That can provide an immediate cashflow a boost. It’s especially beneficial to property owners right now (in 2022) as five-, seven- and 15-year assets are currently eligible for 100% bonus depreciation. That means the entire cost of the asset can be deducted in Year 1. (Unless the law changes, the bonus will be reduced by 20% each year, starting in 2023.) Deducting the full depreciation value can result in serious cashflow benefits.
But there’s a catch. You can’t take advantage of bonus depreciation unless you allocate portions of your assets into subcomponents with shorter depreciable lives.
And there’s only one way to do that: a Cost Segregation Study.
What is a Cost Segregation Study?
A Cost Segregation Study (CSS) is an analysis of your property, performed by qualified professionals, that allocates your total purchase price into its subcomponents. Often, a CSS will identify and segregate subcomponents that depreciate at an accelerated rate (five, seven or 15 years).
If you came to our team for a CSS, we would start by determining whether or not you would likely benefit from one. There is a cost associated with executing a CSS, and we would only recommend one if we determined that you would likely see a valuable return on your investment. While most properties can benefit from a CSS – especially if the owner has constructed or purchased the property in recent years, or expanded or remodeled – there are cases in which the return isn’t worth the investment.
If we determine that you could benefit from a CSS, we will hand your case over to a trusted team of engineers, who will start by breaking down your property into its subcomponents, such as plumbing and electric systems, in order to segregate these components based on their depreciation life. This process is different for each property, but it usually includes a review of all available financial records and blueprints, as well as a physical inspection, when appropriate.
Some items with accelerated depreciation life include:
- Items found within the building that are not considered part of the building itself, such as equipment, machines, furniture and fixtures. That also includes items that may appear to be part of the building but, for tax purposes, are not, such as reinforced flooring to support heavy machinery or a cooling system for an on-site data center. Items that are considered part of the building – and therefore do not qualify for accelerated depreciation – include walls, windows, HVAC systems, and wiring.
- Qualified Improvement Property (QIP), which refers to any improvement made by you, the taxpayer, to an interior portion of an existing commercial building. This includes improvements such as the installation or replacement of drywall, plumbing, or electrical systems. It pretty much includes any improvements besides those related to structural framework, enlarging the building, or elevators or escalators.
- Certain land improvements, such as installing a new fence or upgrading your parking lot.
Once we have segregated the components of your building, we can assign them the appropriate depreciable life. The idea is to distinguish assets that are depreciated as real property (39 years for commercial and 27.5 years for residential) and those that depreciate over shorter periods: 5, 7 or 15 years.
And many components of your building will likely fall into the latter category. On average, 20 to 40% of a property’s total costs are eligible for accelerated depreciation rates. Once we have identified those components , we can file your tax return using these accelerated rates, which often results in deferred federal and state income taxes and increased cashflow.
CSS is for existing real-estate owners, too
Cost Segregation studies are often performed on buildings that a property owner is currently constructing or has recently purchased. However, studies can also be performed for existing real-estate owners. Even years after the initial purchase, this can result in immediate cashflow benefits.
For example, let’s say you purchased a non-residential building, meaning its depreciation rate was 39 years. You bought the building 10 years ago for $1M. Now, after having a Cost Segregation Study performed, 20% of its original cost has been separated as five-year property (meaning it has a five-year depreciation life). That would mean, since it has already been more than five years, you are immediately entitled to deduct the remaining undepreciated $200K in the year of the study, giving a boost to your cashflow.
What are the benefits?
A Cost Segregation Study can help you:
- Generate immediate cashflow by accelerating your depreciation tax deductions.
- Write off expenses. By quantifying your property’s major components and improvements, a CSS enables you to write off these investments when replaced or renovated. For example, if you replace the roof on a building, you can write off the remaining cost of the original roof that has not yet been depreciated.
- Stay compliant. By working with a qualified third-party for your CSS, you will be prepared in the event of an IRS review.
Why now may be the perfect time for a CSS
Cost Segregation Studies aren’t anything new; businesses have been using them for years. However, new legislation makes this strategy more valuable than ever.
Here’s the short version: In 2017, the Tax Cuts and Jobs Act (TCJA) enhanced certain depreciation-related tax breaks. For many businesses, one of the best aspects of the new law was that it expanded the 15-year-property treatment to apply to Qualified Improvement Property. In other words, it allowed businesses to accelerate depreciation on more of their assets, enabling them to reduce their tax burden and improve their immediate cashflow.
That was the idea, anyway. Unfortunately, an error in the TCJA made it impossible for most businesses to actually benefit from the law. The Treasury and IRS claimed to have no authority to fix the error, leaving businesses out in the cold.
Now, more recent legislation in the CARES Act fixed the glitch in the TCJA, allowing businesses to benefit from the expanded 15-year-property depreciation treatment—both for upcoming returns and for retroactive returns as far back as January 1st, 2018.
That new legislation, combined with the 100% bonus depreciation we mentioned above, means that 2022 may be the right time for a CSS.
A Cost Segregation Study can help you identify tax-savings opportunities and improve your immediate cashflow, while staying 100% compliant.
At Dugan & Lopatka, our team has worked with partner engineering firms to execute numerous Cost Segregation Studies. We can help you determine your potential ROI from a CSS and execute this smart tax strategy, so you can get the tax benefits you deserve.