Property owners can use cost segregation to identify components of their property that qualify for accelerated depreciation, allowing them to reduce tax liability and increase cash flow early on in the ownership of the real estate.
Commonly referred to as cost segregation study and accelerated depreciation method
Do I Qualify for the Cost Segregation?
If you’ve recently purchased real estate, you can use cost segregation to separate out components of the property that depreciate faster than the building as a whole, allowing you to increase cash flow and reduce tax liability in the early years of owning the property.
2022 Cost Segregation Details
Commercial and residential property owners who have recently purchased real estate can use cost segregation to separate out components of the property that depreciate faster than the building as a whole. Depreciation refers to the decrease in an asset’s value over time.
How does Real Property Depreciation work?
Real property (e.g., houses, commercial buildings) is not expensed in the year that it is purchased. Instead, it is considered a long-lived asset and is depreciated over its useful life — 27.5 years for residential real property and 39 years for commercial real property. This means that on a $1 million commercial property, for example, you would only be able to take $25,641 per year in depreciation ($1 million / 39 years).
If you keep the property for the full 39 years, the entire $1 million (in this example) would be depreciated; however, it is generally considered more valuable to take an expense today, rather than later. Cost segregation may allow you to do just that with real property.
How does Cost Segregation work?
When you purchase real property, you typically purchase the whole asset: a building and land. You will not be able to depreciate the land, but a cost segregation study can be performed to identify other classes of assets within the building.
A cost segregation study is completed using either software or a consulting firm. The study will separate out personal property items in a building, such as carpeting, light fixtures, kitchen appliances, landscaping, driveways, sidewalks and decks, into shorter class lives (5, 7 and 15 years). The shorter asset life classes can use accelerated depreciation, which allows for higher depreciation expenses in the first few years and lower expenses later on. These assets may also qualify for bonus depreciation or Section 179 expensing.
The cost segregation study will not increase the overall depreciation that can be taken on the building, just accelerate depreciation in the first years of ownership. This means that depreciation in later years will be less. Compared to straight line depreciation at 27.5 or 39 years on the building, a cost segregation study can create significant tax savings in the earlier years of the ownership of the building.
Properties with values greater than $500K should have a cost segregation study completed by a firm that specializes in preparing the studies.
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• Can increase overall deductions in earlier years to reduce taxable income.
• Can allow for bonus depreciation or Section 179 expensing of property that wouldn't otherwise qualify.
• Reduces depreciation deductions that can be taken in later years.
• Must pay for cost segregation study (software or consultant).
• Can significantly increase chances of audit.
Assumptions When Taking the Cost Segregation
• You have owned the building for a short period of time, so you can still benefit from additional depreciation.
• None noted.
Requirements to Claim the Cost Segregation
• You must have an ownership right in real property.
You must complete a cost segregation study.
For properties valued at over $500K, an expert evaluation is recommended.
Business Entities That Can Claim the Cost Segregation
• Schedule C
• Schedule E
• Schedule F
• Farm Rental
• S Corporation
• C Corporation
The material discussed on this page is meant for general illustration and/or informational purposes only and is not to be construed as investment, tax, or legal advice. You must exercise your own independent professional judgment, recognizing that advice should not be based on unreasonable factual or legal assumptions or unreasonably rely upon representations of the client or others. Further, any advice you provide in connection with tax return preparation must comply in full with the requirements of IRS Circular 230.