Cost segregation is a tax planning strategy that involves the segregation and proper recovery period classification of a building’s components. By completing a cost segregation analysis, taxpayers can take advantage of accelerated depreciation deductions and reduce their overall tax liability.
Cost segregation is based on the concept that the components of a building have varying depreciable lives. When a building is put into use, it is typically depreciated over a period of 39 years (or 27.5 years for residential properties). As a result, you can claim annual depreciation deductions during the building’s depreciable lifespan.
Cost segregation allows you to front-load your depreciation deductions by segregating the various building components for accelerated depreciation (typically five years, seven years, and fifteen years). These components are often related to the operation and maintenance of the business rather than the building itself. The outcome is a potentially significant depreciation deduction that can offset a current year's tax liability.
Bonus depreciation rates will factor in the amount of tax savings for the first year the building was placed into service. Tax year 2022 was the last year for 100% bonus depreciation. It has officially dropped to 80% for 2023 and will drop an additional 20% each tax year through 2026.
In order to properly segregate the building components, it is important to work with a qualified engineer or professional who can accurately identify the various components of your property.
A quality study can result in all of the building components being broken down and assigned to appropriate depreciable recovery periods.
As an example, when looking at a typical office building, recovery periods could potentially include:
Eide Bailly’s cost segregation approach includes various elements to ensure you’re receiving the maximum benefit. Our process includes:
If you are paying significant taxes and are in a higher bracket, the benefit of a cost segregation study is easier to determine. If you are in a low bracket and have most of your income sheltered through other depreciation or other deductions, then the benefit of a cost segregation study is not nearly as significant.
With that said, deductions are not necessarily the only benefit of completing a study. Componentizing the building assets can aid with future repair expenses and partial dispositions.
Note there can be limitations on a taxpayer’s ability to claim losses, including the passive activity rules, the at risk rules, the basis limitation rules and the overall business loss rules.
There are a variety of businesses that can materially benefit from a cost segregation study. Examples include:
A business recently purchased a $6 million business park in 2022. As a result of a cost segregation study, the owner was able to generate almost $555,000 in tax savings in the first year utilizing 100% bonus depreciation.
When a business recently built a $15 million manufacturing facility, a cost segregation study, coupled with 100% bonus depreciation on qualified property, gave the owner a first-year tax deduction of $4.75 million.
A dental practice renovated their existing space for $1.5 million in 2022. It was determined that $725,000 fell into the Qualified Improvement Property (QIP) bucket which is depreciated over fifteen years with 100% bonus depreciation, and $200,000 was determined to be five-year property.
QIP describes any improvement that is Sec.1250 property made by the taxpayer to an interior portion of a nonresidential building placed in service after the date the building was originally placed into service. However, there are various improvements that do not qualify for QIP, which increases the importance of having a qualified individual perform the cost segregation analysis. A partial disposition analysis was also performed on the assets that were disposed of and resulted in an additional $300,000 in deductions. The total analysis yielded approximately $360,000 in year one tax savings.
If you own real estate, cost segregation can be a beneficial tax planning tool. IRS rules allow taxpayers to apply a cost segregation study any time after the building is purchased, renovated, or constructed, which provides a unique opportunity to plan which tax year depreciation deductions are realized.
Cost segregation is just one of many opportunities to increase cash flow. Find out about your cost segregation and other potential incentive opportunities with our free assessment.
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