Tax Benefits

A residence, office building, warehouse or any other real property is never just the structure alone. It also includes several other elements, such as plumbing fixtures, carpeting, sidewalks, fencing and a lot more.

If you were to purchase these assets by themselves, you could depreciate them over 5, 7 or 15 years. However, since they are purchased as part of a building acquisition or a new development, they are usually written off over the same useful life as the rest of the building, namely 27.5 or 39 years.

A cost segregation study is a process that looks at each element of a property, splits them into different categories, and allows the owner to benefit from an accelerated depreciation timeline for some of those building components.   

Why Does a Cost Segregation Study Matter for Property Owners?

Segregating the costs of a property matters because of the financial benefits it provides. While the study has an up-front cost, the tax savings from accelerating depreciation deductions can result in significantly increased cash flow over several years.

With a cost segregation study, owners get the benefits of time value of money. However, if you do not plan to hold the property for the long term, you may not get any benefit from having a cost segregation study because any up-front benefits reverse upon the sale of the property.  

Who Performs Cost Segregation Studies?

It typically involves a team of tax advisors and engineers working together to decide which components of a building should go into each category and how much each element costs on its own. To accomplish this, your advisory team reviews available property records, inspections, cost details and blueprints and may also perform a physical inspection of the property.  

How Does Cost Segregation Work?

The goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7  and 15 years—or written off faster using bonus depreciation. 

What are the new depreciation rules for 2023?

The rules allowed Bonus Depreciation to 100% for all qualified purchases made between September 27, 2017, and January 1, 2023. Bonus Depreciation now ramps down to 80%, starting in 2023. Bonus depreciation will continue to ramp down for ensuing years: 60% for 2024, 40% for 2025, 20% for 2026, and 0% beginning in 2027. 

Cost Segregation Study Example

For example: you buy an office building for $1,000,000. Since land is not depreciable,  you could allocate the total acquisition cost between land as being worth $200,000 and the building as being worth $800,000.

If you depreciate the building’s cost over 39 years, your depreciation write-off would be $20,513 per year. Assuming a 37% federal income tax rate, that would save you roughly $7,590 in taxes.

Now, let us say you decide to get a cost segregation study. After completing the study, your advisory team identifies the following costs, totaling $300,000:

  • $100,000 of interior fixtures and finishes that can be depreciated over 5 years
  • $100,000 of interior fixtures that can be depreciated over 7 years
  • $100,000 of land improvements that can be depreciated over 15 years

 

Based on the study, 80% of the $300,000, or $240,000 of the building’s $800,000 is eligible for bonus depreciation in 2023, (see above how the bonus depreciation rule changes over time). Assuming a 37% tax rate, that would result in tax savings of $88,800 over depreciating the building with no cost segregation.

However, even if you did not take advantage of bonus depreciation, those items could be depreciated over a shorter recovery period using an accelerated depreciation method. As a result, your estimated first-year depreciation write-off would be:

  • Building ($500,000 / 39 years): $12,821
  • 5-year property ($100,000 / 5 years): $20,000
  • 7-year property ($100,000 / 7 years): $14,286
  • 15-year property ($100,000 / 15 years): $5,000 

Total first-year depreciation expense: $52,107

So even if you did not take advantage of bonus depreciation, your first-year depreciation write-off would result in a tax savings of $11,690 over depreciating the building over 39 years with no cost segregation (($52,107 – $20,513) x 37%).

When Is the Best Time to Get a Cost Segregation Study?

The best time to conduct a cost segregation study is in the year the building is acquired, constructed or remodeled. However, you may have a look-back study done any time afterwards and claim the resulting write-offs without amending prior-year tax returns.

ME Real Estate does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and it is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. 

2. Depreciation

Depreciation is a reduction in the value of an asset with the passage of time, due to wear and tear.

Real estate depreciation is defined as an income tax deduction that allows a taxpayer to recover the cost (or other basis) of a real estate investment. The depreciation is realized as a type of deduction that reduces the investor’s taxable income.