Adding to the bottom line is the ultimate goal of every business. There are, of course, a multitude of methods a business can employ to achieve this goal. If you hold commercial real estate, a Cost Segregation Study might just be the method for you!
What exactly is a Cost Segregation Study?
Simply put, a Cost Segregation Study enables you to reallocate part of the cost basis of a purchased or newly constructed commercial property into multiple asset classes, allowing for accelerated depreciation of a percentage of the property’s cost basis. This depreciation results in a deduction under the tax code, lowering your tax bill and boosting cash flows. The IRS suggests the following asset categories into which the asset cost basis can be allocated:
- Personal Property
- Land Improvements
- Building
- Land
How does Cost Segregation help?
“A bird in hand is worth two in the bush”
Front-loading your depreciation benefit will let you take advantage of the time value of money. By identifying personal property and land improvement components that would have otherwise have been lumped in with the total cost of the asset, a Cost Segregation study helps businesses depreciate their assets at an accelerated rate and, in some cases, even expense the accelerated property immediately.
Personal property such as furniture, fixtures, equipment, some flooring types, etc., have relatively short depreciable lives (five years). On the other hand, the normal depreciable life of buildings and other real estate assets is 27.5 years (for residential real estate) and 39 years (for commercial non-residential real estate). By treating components as personal property and land improvements, your commercial property assets will be eligible for much shorter life spans. The shorter the depreciable life of the asset, the greater your depreciation deductions and greater tax savings.
Cost Segregation also allows you to take advantage of bonus depreciation for qualified assets in the first year in which the asset is put in service. The 2018 Tax Cuts and Jobs Act (TCJA), for instance, has increased the bonus depreciation available for 5, 7, and 15-year assets to 100% of the depreciable basis. By segregating your cost basis, you can take advantage of the bonus depreciation deduction available for personal property and qualified improvement property.
Furthermore, the TCJA has also introduced the “new to the taxpayer” concept wherein a taxpayer can claim bonus depreciation for even previously used properties so long as the owner has not had a previous depreciable interest in the property. In other words, if you purchase commercial real estate property from a third party, you can claim bonus depreciation in the first year in which you place the asset in use for your business. Your real estate asset need not be a new asset for you to claim bonus depreciation.
Let’s illustrate the benefits of a Cost Aggregation Study through an example
Tim is the owner of a multi-unit apartment complex, which he purchased in 2020 for $1.5 Million. He wants to record the depreciation costs for the 2020 tax year for his property. Other details are as below:
- Land Value included in the Purchase Price of the Building = $500,000.00
- Depreciable life of the Asset (apart from the land and per tax laws) = 27.5 Years
- Marginal Tax Rate = 40%
- Applicable Bonus Depreciation for the year 2020 = 100%
- Depreciation Method followed for Long Life Property = Straight Line Method
Tim’s CPA calculates the depreciation for his property as follows:
| Building Value (A) | $1,500,000 |
| Less: Land Value (B) | $500,000 |
| ———– | |
| Depreciable Basis [C= (A-B)] | $1,000,000 |
| Depreciable Life of the property (D) (Not Bonus Eligible!) |
27.5 |
| 1st Year Depreciation Deduction [E= (C/D)] (Half-Year Convention for Convenience ) |
$36,364/2 $18,182 |
| Marginal Tax Rate (F) | 40% |
| *1st Year Cash Flow due to depreciation [G=(E*F)]1 | $7,273 |
Tim wonders if there is a better way to increase his tax savings due to depreciation and, in turn, increase free cash flow. His CPA suggests that Tim should explore the option of undertaking a Cost Segregation Study to save on his tax bills and increase cash flow. He also informs Tim that by segregating his acquisition cost, he can qualify for Bonus Depreciation on personal property and qualifying land improvements. Tim’s interest is piqued, and he hires a team of experts to conduct the study.
The team conducts the Cost Segregation Study and segregates the asset cost of $ 1.5 Million into the following asset categories:
| Building Value (A) | $1,500,000 |
| Less: Land Value (B) | $500,000 |
| ———– | |
| Depreciable Basis [C= (A-B)] | $1,000,000 |
| Personal Property / 5 Year Assets (D1) 12% of $1,000,000 (100% Bonus Eligible!) |
$120,000 |
| Land Improvements / 15 Year Assets (D2) 17% of $1,000,000 (100% Bonus Eligible!) |
$170,000 |
| Real Property (Building) / 27.5 Year Assets (D3) 71% of $1,000,000 (No Bonus & 1/2 Year Convention) |
$710,000/27.5 $25,818/2 $12,909 |
| 1st Year Depreciation Deduction [E= (D1+D2+D3)] | $302,909 |
| Marginal Tax Rate (F) | 40% |
| 1st Year Cash Flow due to depreciation [G2=(E*F)] With Cost Segregation |
$121,164 |
| *1st Year Cash Flow due to depreciation [G1=(E*F)] Without Cost Segregation (from Example Above) |
$7,273 |
| 1st Year Increased Cash Flow with Cost Segregation [GIncrease=G2-G1] | $113,891 |
Through the segregation of assets, the team found an increased depreciation deduction/tax savings of $302,909 and increased cash flow of $121,164 in the first year.
That’s an additional cash flow increase of $113,891 in the first year with a Cost Segregation!
| Year | 5-Year Assets | 15- Year Assets | 27.5-Year Asset | Depn Dedn With Cost Seg |
Depn Dedn Without Cost Seg |
Inc Depn Dedn | Inc Cash Flow @40% |
| 1 | $120k | $170k | $12,909 | $302,909 | $18,182 | $284,727 | $113,891 |
| 2 | 0 | 0 | $25,818 | $25,818 | $36,364 | ($10,545) | ($4,218) |
| 3 | 0 | 0 | $25,818 | $25,818 | $36,364 | ($10,545) | ($4,218) |
| 4 | 0 | 0 | $25,818 | $25,818 | $36,364 | ($10,545) | ($4,218) |
| 5 | 0 | 0 | $25,818 | $25,818 | $36,364 | ($10,545) | ($4,218) |
Cost-Benefit Analysis
Many small businesses shy away from conducting Cost Segregation studies as they believe it to be cost-prohibitive. The simple truth is Cost Segregation Studies come at a cost but can be economical even for properties with a basis of as small as $300,000! You can even write off the cost of the study itself, that’s a win-win!
Another common reason for hesitation is the fear of depreciation recapture on the sale of assets. Though you may end up showing the recapture as ordinary income when you sell your asset at a profit, remember that this will be taxed at the capital gains rate. In contrast, if you had not used a Cost Seg study to offset your ordinary income in the present, that income would have been taxed at your marginal tax rate (which is certainly higher than the Capital Gains rate).
I’m glad you mentioned certain hooks in the tax code. I need to get an accountant to help me file for 2021. I just don’t know how to do my deductions.