Cost Segregation Studies Can Accelerate Businesses’ Tax Savings
Cost Segregation Studies Can Accelerate Businesses’ Tax Savings
Cost segregation studies, which are a method of tax planning that reclassifies real estate assets to help accelerate depreciation deductions, are an underused financial tool in commercial real estate and property.
The benefits of cost segregation go beyond tax deferral. They can unlock value for property owners, investors, and businesses, and provide immediate tax relief and enhance liquidity, which can be valuable during economic downturns or periods of volatility.
They also can offer current-year tax benefits from properties already in service rather than being solely relevant in a property acquisition or new construction project. Studies can be implemented retroactively, allowing taxpayers to recapture, on the current-year tax return, accelerated depreciation deductions that should have been claimed in past years.
Regulatory changes affect the magnitude and type of benefits available through cost segregation studies. The Tax Cuts and Jobs Act1 introduced changes that made cost segregation even more advantageous.
For example, it allows for bonus depreciation on qualifying property, which could be fully or partially expensed depending on the year it’s placed in service. Under the TCJA, bonus depreciation phases down from 100% for property placed in service after Dec. 31, 2022. Qualifying property placed in service in 2023 is eligible for 80% bonus; in 2024 for 60% bonus; in 2025 for 40% bonus; and in 2026 for 20% bonus.
The Inflation Reduction Act2 introduced several energy credits aimed at promoting clean energy and reducing carbon emissions. Complex rules govern the eligibility of assets and expenditures, which cost segregation studies can identify and quantify.
Given these factors, cost segregation is a relevant and valuable strategy for property owners looking to optimize their financial and tax positions. Below are eight areas where cost segregation analyses prove beneficial.
Accelerated Depreciation and Tax Savings
A cost segregation study breaks down the components of a property into various asset classes, allowing for accelerated depreciation of certain elements.
By reclassifying building components such as electrical systems, plumbing, and certain finishes into shorter depreciation categories (five or seven years, rather than the standard 27.5 or 39 years for residential rental and commercial properties, respectively), property owners may be able to shrink their taxable income in the early years of ownership.
Cost segregation studies ensure compliance with IRS regulations with approved engineering procedures and methodologies for determining asset values. This is crucial in the event of an audit, as it substantiates the benefit claimed.
Enhanced Cash Flow Management
Property owners can redirect the tax savings realized through accelerated depreciation toward paying down debt, funding capital improvements, or even expanding the business. This increased liquidity provides flexibility and a competitive edge in the marketplace.
Strategic Planning for Property Transactions
For buyers, understanding the potential tax benefits of a cost segregation study can influence purchasing decisions and clarify a property’s true value. Sellers can use the results of a cost segregation study to make their property more attractive by highlighting potential tax savings for prospective buyers.
During renovations, a cost segregation study can help identify which components qualify for accelerated depreciation or immediate expensing, optimizing the financial impact of the improvements.
Improved Financial Reporting and Forecasting
A cost segregation study provides a detailed breakdown of a property’s components, resulting in more precise financial statements. This can improve budgeting, forecasting, and financial analysis, and enable better strategic decision-making. Investors and stakeholders can learn more about the financial health and performance of the property, fostering greater confidence and trust.
Industries such as hospitality have extensive useful life classifications that must be assigned to development assets. Cost segregation engineering methods ascribe value to those assets when they can’t be identified through construction cost data or appraisals. Having this level of detail allows fixed asset managers to identify assets for disposal or retirement easily.
Optimization of Property Tax Assessments
Documentation from a cost segregation study provides a clear and comprehensive inventory of a property’s assets, helping to identify specific components that may be overvalued in property tax assessments. By demonstrating that certain components should be valued differently, property owners may be able to reduce their overall tax liability.
Cost segregation analyses can be particularly useful in property tax appeals and audits by providing a well-documented basis for asset valuation.
Alignment With Sustainability and Energy Efficiency Initiatives
Real estate has been focusing on sustainable building practices and integration of technology. Properties that use renewable energy sources often qualify for additional tax incentives and accelerated depreciation. A cost segregation study can identify the tax credit eligible property and quantify the related expenditures.
Estate Planning and Wealth Transfer Benefits
Real estate held in a trust typically is reassessed to its fair market value at the date of a grantor’s death — a process often called a “step-up in basis.” This new valuation can have significant tax implications, particularly for the beneficiaries inheriting the property.
By allocating the new basis, a cost segregation study will maximize the depreciation deductions and reduce taxable income. Understanding the depreciation schedule of property assets can help families make more informed decisions about gifting or transferring property to the next generation.
Optimizing Tax Outcomes Under FIRPTA
The Foreign Investment in Real Property Tax Act3 imposes tax withholding requirements on foreign investors selling U.S. real property interests. By accelerating depreciation, adjusting the property basis, and enhancing cash flow, cost segregation studies help minimize FIRPTA-related tax liabilities and improve overall financial performance. The detailed documentation of asset values in cost segregation studies supports accurate tax reporting and compliance with FIRPTA requirements.
Incorporating cost segregation into financial planning allows property owners to stay current with regulatory changes to ensure maximum tax benefits and compliance. As economic and regulatory environments continue to evolve, the relevance and value of cost segregation studies will only grow.
This article was originally published in Bloomberg Tax.
