Commercial real estate investments are not only lucrative but also come with a variety of tax planning opportunities. Among the most advantageous, yet underutilized, strategies is the cost segregation study. This technique allows property owners to accelerate depreciation deductions, thereby reducing taxable income and enhancing cash flow.
Understanding Cost Segregation
Cost segregation is an engineering-based approach to identify and reclassify personal property assets and land improvements that are traditionally depreciated over 39 years into shorter depreciation periods. Property owners can benefit from accelerated depreciation deductions, resulting in significant tax savings.
The Mechanism of Cost Segregation
A cost segregation study involves a detailed analysis of building components to segregate assets into different classes. Components such as lighting, flooring, plumbing and landscaping can often be reclassified from the standard 39-year depreciable life to five, seven or 15 years. This reclassification allows for accelerated depreciation, which reduces taxable income in the early years of property ownership.
Economic Benefits
The most immediate economic benefit of cost segregation is improved cash flow. By accelerating depreciation deductions, property owners reduce their taxable income, which in turn reduces their tax liability. In addition, the tax savings generated through accelerated depreciation can significantly boost the return on investment. The additional cash flow can be utilized for property improvements, debt reduction or expanding one’s investment portfolio.
Tax Benefits
Accelerated and Bonus Depreciation. By reallocating certain assets to shorter depreciation lives, property owners can take larger depreciation deductions in the early years of ownership. This reduces taxable income and the overall tax burden, allowing owners to retain more of their earnings. Cost segregation studies also look for opportunities to take bonus depreciation on eligible property.
Bonus eligible property can also include used assets, which is advantageous to taxpayers who purchase assets that are not original-use, such as bonus depreciation on 743(b) adjustments arising from the purchase of a partnership interest. Bonus depreciation for the 2025 and 2026 tax years is set to be 40% and 20%, respectively.
Reduction in Current Tax Liability. The primary tax benefit of cost segregation is the reduction in current tax liability. By accelerating depreciation, property owners can lower their taxable income, resulting in substantial tax savings. These savings are particularly valuable for new acquisitions and recently constructed properties.
Potential for Catch-Up Depreciation. If a cost segregation study is conducted on a property that has been in service for several years, the owner can catch up on the missed depreciation deductions. fThis is achieved through a one-time adjustment known as a Section 481(a) adjustment, allowing for immediate tax savings.
Real-World Application. Consider a commercial retail property purchased for $7 million, with $5 million allocated to the building and improvements and $2 million allocated to land. Without a cost segregation study, the property would be depreciated over 39 years, resulting in an annual depreciation deduction of approximately $128,205.
However, with a cost segregation study, certain components can be reclassified, allowing for accelerated depreciation. Suppose $1.5 million of the property’s cost is reallocated to five- and seven-year property and another $500,000 to 15-year property. The annual depreciation deductions for the first five years would significantly increase, leading to substantial tax savings.
The tax policies of the new administration are still evolving. There is a possibility that 100% bonus depreciation could return, which would greatly benefit the real estate industry.
Legal and Compliance Considerations. It is crucial to ensure that a cost segregation study is conducted by qualified professionals, such as engineers or certified public accountants with expertise in this area. The IRS has specific guidelines and requirements for cost segregation studies, and non-compliance can result in penalties and disallowed deductions.
Conclusion
A cost segregation study offers compelling economic and tax benefits for commercial retail real estate property owners. By accelerating depreciation and reducing taxable income, property owners can improve cash flow, increase property value and enhance ROI.
As with any tax strategy, it is important to consult with tax and financial professionals to ensure compliance and maximize the benefits of a cost segregation study. Property owners who overlook this powerful tool may miss out on significant tax savings and economic advantages. Therefore, considering a cost segregation study can be a game-changer in the realm of commercial real estate investment.
Final Thoughts
As the real estate market continues to evolve, savvy investors and property owners must leverage every available strategy to enhance their financial standing. Cost segregation stands out as a proven method to achieve these goals, providing immediate and long-term benefits that contribute to overall investment success.
Sean Burke
Managing Director
CBIZ
53 State St., 17th Floor
Boston, MA 02109
sean.burke@cbiz.com
(617)807-5116
