Building Value: Cost Segregation

Cost Segregation is a commonly used strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase after-tax cash flow by accelerating depreciation deductions and deferring federal and state income taxes.

What is a Cost Segregation Study & How Does it Work?

When a property is purchased, not only does it include a building structure, but it also includes all of its interior and exterior components. On average, 20% to 40% of those components fall into tax categories that can be written off much more quickly than the building structure itself. A Cost Segregation Study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27 ½ or 39 years. The primary goal of a Cost Segregation Study is to identify all property-related costs that can be depreciated over 5, 7 and 15 years. For example, certain electrical outlets that are dedicated to equipment such as appliances or computers can be depreciated over 5 years.

By segregating out these assets, owners can depreciate certain components of the property more quickly which can create lower taxable income and possibly even losses in the first few years of owning a property.

MacKenzie Lessons Learned:

  • Evaluate the upfront cost of the Cost Segregation Study with the overall investment plan for a property. There will be an upfront cost to perform the study. If you are planning on selling the property in a few years, there will likely be recapture of some of the tax deferral, so the cost of the study may not be a worthwhile expenditure. On the other hand, if you plan to own the asset for a longer period of time, the Net Present Value of the tax shelter will likely justify the upfront cost.
  • Make sure to properly account for the assets. Your property accountants should be able to input the findings of the study into a software program that allows you to take maximum depreciation of the different components over the life of your investment. Careful attention to the proper initial set-up and diligent tracking of the asset depreciation schedules will pay dividends over the ownership of a property.
  • Continue to segregate building components as you make improvements. All buildings will continue to have improvements made to them in the form of Tenant Improvement or other capital improvements such as a roof replacement over the life of the property. These improvements may be depreciable at vary rates allowing the owners to receive ongoing benefits by helping to offset income.
  • There are additional benefits of a cost segregation study.  Because of the detailed nature of the study, when building systems fail (i.e., the elevators or the roof) or portions of the building are demoed and upgraded, assets are easily identified so that any remaining depreciable value may be written off and replaced.

Real estate is a great investment for many reasons, but the ability to shelter income through proper tax planning and accounting can be particularly beneficial when weighed against other investments. Make sure your property management team and tax accountants are in sync so that you can receive the maximum benefits.

This document is for informational purposes only and should not be construed as tax advice.  Readers should consult their tax advisors before administering any tax planning.