Building Smarter: Cost Segregation Study Basics
Published on by Scott Cress in Construction, Manufacturing, Real Estate, Tax Services
For companies or real estate investors that recently purchased or constructed real estate for business purposes, there’s a compelling federal tax savings opportunity waiting. Unlike most incentives which only require the taxpayer to claim a credit for past activities on the annual return, a cost segregation study works differently.
Rather than (slowly) depreciate the entire real estate property as a single asset, specific assets can be segregated into different components. Once separated, the owner can accelerate depreciation on different components, allowing the taxpayer to write off the basis more quickly and reduce taxable income in the short term. The result: significant savings in the early years of building ownership.
Breaking it down
While it may sound like cost segregation studies create new deductions, they don’t. Instead, they borrow from future years and accelerate depreciation into earlier years.
Typically, real estate depreciates slowly over a prolonged period – 27.5 years for residential and 39 years for nonresidential property. Instead of looking at a building as a single unit, a cost segregation study separates different components from the building that are likely to have shorter useful lives, often 5, 7, or 15 years, which are eligible for bonus depreciation. These include:
- Removable flooring, such as carpet or tile
- Office partitions
- Specialized HVAC
- Built-in shelving and cabinets
- Data cabling
- Specialized plumbing
- Reinforced concrete floors in warehouses or manufacturing facilities
- Specialized lighting and electrical systems
Freeing up more capital, faster
Breaking down a building into its components means the business can claim depreciation on it at a much faster rate. Specialized buildings with more relevant components generally come with better depreciation benefits. In an apartment building, for example, this could include kitchen appliances, cabinetry, and shared facilities such as gyms and pools. In a more industrial setting, buildings made for manufacturing processes can have high-voltage electrical systems, reinforced concrete floors, and other industry-specific machinery subject to regular wear that might be broken out in a cost segregation study.
The complete list of qualifying components will vary from structure to structure. When conducting a cost segregation study, it’s important to collaborate with an expert who can identify these components and generate stronger early deductions.
The cost & benefit of cost segregation studies
Of course, conducting a cost segregation study is an additional expense you’d need to shoulder to reap the benefits, so a logical question is whether it’s worth doing. While benefits vary by study, on average, organizations can expect to enjoy accelerated depreciation somewhere between 17-30%. This means that for a building that costs $1 million, businesses can expect accelerated depreciation of up to $300,000.
What buildings are a good candidate for a cost segregation study?
As a good guideline, buildings that cost at least $500,000 to purchase or build are the best candidates for a cost segregation study. Costs start at about $5,000 to conduct a study, so this ensures the price is well worth the benefit. The lower tax liability offered by a cost segregation study can improve cash flow, making it valuable for businesses looking to free up money to apply to other projects.
Additional considerations
Cost segregation studies speed up aspects of the depreciation process, but this doesn’t mean businesses should invest in them if they’re only sticking around for the short term. Benefits are greater for those who plan to hold their buildings long-term. Businesses looking to turn around and sell properties in a couple of years or dispose of them in other ways won’t benefit as much.
Accelerated depreciation deductions must also be considered alongside a taxpayer’s overall plans to understand the broader impact. For example, if two separate entities own the building and the business, the deduction process will function differently than if they’re under the same umbrella.
Calculate your options
A cost segregation study can open the door to significant tax savings. Since these studies are complex, it is important to consult with a qualified tax advisor to determine how your organization can benefit.
In the market to build or buy a property, or in the early stages of ownership? Barnes Dennig is here to help you navigate the cost segregation process. Connect with a real estate tax pro and start maximizing your tax savings today.
