What Is Cost Segregation Study?
A cost segregation study is an efficient tax-planning tool in which the property is split into smaller individual components so that certain components can be depreciated more quickly than the whole building. According to the standard tax rule, the property of a homeowner is depreciated over 27.5 years, and commercial properties over a period of 39 years. However, many components like carpeting fixtures, lighting and landscaping wear out much faster. Cost segregation studies identify the components with shorter lives and categorizes them into categories that have accelerated time frames for depreciation of 5, 7 or 15 years.
Separating assets doesn’t mean you need to wait for decades for depreciation benefits to be claimed. Instead, the costs are recouped faster, which frees up funds that can be put back into the business, to pay off debt or to support growth of the business. What’s more, many of these short-lived assets qualify for bonus depreciation, allowing you to expense them immediately in the year placed in service. This makes the timing of a study particularly valuable.
Why It’s a Smart Move Financially
At its core, the cost segregation process can reduce tax-paying income by speeding up depreciation which otherwise would be spread out over a long period of time. It can result in cash flow advantages, particularly important when funds are required to finance renovation, acquisition or expansion .
For example, owners of commercial buildings or multi-unit rental properties where fixtures such as flooring, lighting and HVAC units are abundant can reap enormous benefits by shifting significant portions of their costs into shorter periods of recovery. Additionally, bonus depreciation rules generally allow you to write off the entire expense within the first year, amplifying the benefit .
Even owners of properties that are older or held for a long time could gain. Retroactive as well as a retrospective segregation of costs (sometimes called a “look-back”) lets them apply a change to their accounting methods to claim missed depreciation at once using IRS Form 3115.
How It Works: The Process in Practice
Typically, you work with a team of experts, accountants, engineers, and tax advisors who will gather building documentation including blueprints, purchase agreements, contractor invoices, and existing depreciation schedules. A site visit often helps document valuable asset details in person .
With a thorough examination, the assets can be divided into three major categories Personal property (e.g. furniture, carpeting appliances) as well as improvements to the land (e.g. parking lots, sidewalks, fences) and the structural components of a building (which remain on the standard long depreciation schedule). This involves line-item cost allocation supported by engineering rationale.
After classification, actual cost reallocation takes place, transferring amounts from the long-life category to asset categories with shorter lives. This results in a dramatic increase in depreciation which can be reported in the same year’s tax return or implemented through the catch-up method used for previous years .
The process ends with a comprehensive report that includes photographs, cost breakdowns, the classification method, and the necessary compliance documents. This is the basis to prove deductions and aid in possible audit questions .
Timing and Qualification: When It Makes Sense
Cost segregation studies are an ideal option for the time of purchase of a new construction project or major renovations, where invoices and blueprints are easily accessible and bonus depreciation is already in place . Completing it within that same year will allow you to take advantage of bonuses depreciation immediately.
Even when the window has closed, look- back studies are still an alternative. They leverage IRS allowances for accounting changes to accelerate uncaptured depreciation from prior years in one fell swoop .
Costs associated with the engagement are usually measured in the lower thousands. Although capturing the benefits requires meticulous documentation and expert guidance as well as feedback from the owner, case studies reveal that results often exceed costs, even for smaller buildings .
Real-World Results and Feedback
A number of professionals have reported remarkable results. One investor shared how they achieved an increase of 17x on costs of the study, spending around $1,800 while receiving over $30,000 of tax savings for a modest rental property. Another investor described the advantages of professional reporting and documentation helped protect audits with great value.
For commercial purposes there are studies that show tens of thousands of dollars in the first year of acceleration of deductions. Commercial owners with large assets often reduce their expenses by hundreds of thousands of dollars, which makes the practice a commonplace in the modern world of real accounting for real estate .
Things to Keep in Mind
While effective cost segregation is a powerful tool, it’s not completely secure or suitable for all situations. The initial cost, which is typically several thousand dollars must be evaluated against the expected acceleration of depreciation particularly for smaller properties .
IRS regulations require meticulous and detailed documentation based on engineering. Skimping or “DIY” reports can raise suspicions and prompt scrutiny, making professional involvement essential .
There’s also the possibility of recapture of depreciation. Accelerated deductions will result in lower tax liabilities after the sale of the home, unless alternative strategies like a 1031 exchange are employed .
Strategic Planning for Long-Term Benefit
Cost segregation can provide flexibility above immediate depreciable benefits. It helps improve financial projections as well as plans for portfolios by increasing the internal rates of return, enhancing cash flow models and incorporating into strategies for acquisition or sale timing .
Additionally, a careful classification can also help lower property taxes and could help determine tax credits for energy efficient assets under various state and federal laws . For property that is part of trusts or estates, the Accelerated depreciation helps with basis-stepped strategy and the generational transfer of wealth .
Getting Started: What You Need to Know
The preparation is crucial. To begin, make sure your property is a great candidate, newly constructed or acquired and renovated, or having an adequate depreciable basis. Assess the tax bracket you fall in and determine if your income level will allow you to get the most benefit by accelerating deductions or long-term depreciation. If you missed the deadline, consider whether you should conduct a look-back study using Form 3115 .
Once you’ve decided to proceed, choose a reputable provider engineer-led, CPA-backed, and with strong audit defense. Make sure you have all the relevant documentation available and prepare for an on-site inspection. Contact your tax professional to coordinate the carrying deductions on the tax year that is in progress or on your previous tax return .
Why Parr & Ibarra CPA Should Be Your Partner
We blend tax knowledge and technical expertise with dependable cost segregation engineers. We surpass compliance and concentrate on providing maximum, legal benefits tailored to your specific property. We can help you maximize bonus depreciation and claim any benefit from look-backs and help you manage any possibility of a depreciation recapture or sales period tax planning. In addition, we’re at your side every step of the way, documenting your actions, defending and offering advice to ensure that audits run smoothly and up-to-date strategies to meet the changing tax law.
Final Thoughts
Cost segregation isn’t an unintentional tax trick, but rather an established, IRS-approved method to align depreciation to the actual life span of the building’s components. No matter if your home is brand new or seasoned, bought or renovated, whether commercial or a rental property, the utilization of cost segregation will increase tax savings and help you cash planning.
If you’re looking to determine whether your home is eligible for a cost segregation study or to conduct a look-back exam, get in touch with us today at Parr & Ibarra CPA. We’ll look at the potential and value and help you develop an informed, accurate and cash-smart tax strategies for real estate.
