10 Most Common Cost Segregation Questions: Answered

Cost segregation is the key to real estate savings but is often misunderstood. Certain questions arise frequently, and we’ve compiled answers to the top 10 we receive here.   

1. What is a Cost Segregation Study?  

Any given property contains a multitude of different assets, and each of them may be expected to have a different useful life. For example, you can confidently expect ceramic flooring to last a lot longer than say, carpet flooring. Tax law provides guidance of how to expense capital expenditures by using a baseline of what the various assets’ expected useful lives would be. Using the Modified Asset Cost Recovery System (MACRS), the default MACRS class-life for nonresidential real property is 39 years, and 27.5 years for residential real property. This means that if no cost segregation study is performed, assets will typically be depreciated over either 39 years or 27.5 years, depending on the property type. Going back to our example above, while using a longer depreciable life might make sense for ceramic flooring, it would not appear to make sense for carpet flooring.  

Categorizing Building Assets for Depreciation  

In a cost segregation study, engineers identify and quantify the various building assets, and assign each asset a cost by use of IRS approved pricing guides. These costs are then segregated into different categories according to their depreciable asset class lives. Base building or “shell” assets remain in their default MACRS class-life for real property; however, many assets can be moved into shorter-lived class lives:  

• 5-Year Assets: carpet flooring, countertops, breakroom sinks, cabinetry and decorative moldings, specialty lighting, dedicated outlets, fire extinguishers and more
• 7-Year Assets: office furniture
• 15-Year Assets: land improvements like drainage pipes, parking lots, landscaping, outdoor swimming pools, protective bollards, sidewalks, and more  

By segregating these assets into shorter-lived categories, they can be depreciated more quickly, resulting in tax savings and increased cash flow.   

2. Can I Do a Cost Segregation Study Myself?  

Since the concept of cost segregation is fairly easy to grasp, many people think that performing a cost segregation study must be easy as well. A quality cost segregation study is not a simple task and requires the skills and experience of a trained engineer. 

Engineers must draw on their knowledge of construction methods and related costs as they meticulously work their way through a project site, laboring to account for every possible asset. During the site visit, engineers will perform a forensic analysis of the property’s unique details. Then assets will be “broken-out,” assigned costs, and finally placed in the appropriate class-life category. Study results must then be analyzed from tax and technical perspectives, to determine complete accuracy and comply with IRS regulations.   

IRS’ Guidelines for Cost Segregation  

In fact, the IRS’ Cost Segregation Audit Techniques Guide lists 13 “Principal Elements of a Cost Segregation Study.” The very first element is “Preparation by an Individual with Expertise and Experience,” and the Guide explicitly states that: “… a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background.” 

In short, studies should be performed by experienced engineers who can provide reports that maximize savings while remaining defensible in the unlikely event of an audit.  

3. Is Cost Segregation Really Worth It?  

Cost segregation can certainly be “worth it” in terms of return on investment. Cost segregation fees vary, and are generally commensurate with a project’s scope, size, and complexity. The usual return on investment for a cost segregation report is well over 10-to-1.  

Cost segregation bestows benefits beyond accelerated depreciation. The study can provide the data needed to support a myriad of other tax strategies; preparing you for savings in the future.  

Additionally, the right provider will stay up to date on current legislation. If new savings opportunities become available, your cost segregation study can be revisited, adding even more return to your modest investment.  

Because cost segregation is so nuanced, and the facts and circumstances of every project vary, online calculators can provide a general estimate at best. A quality cost segregation provider will provide you with a complimentary estimate of benefits after reviewing your fact pattern.  

4. What Kinds of Real Estate Can Cost Segregation Be Performed? 

Properties like office buildings, hotels, and retail spaces often come to mind when people think of cost segregation. However, it can be performed on any type of commercial real estate, as well as on residential real estate including apartment buildings, dormitories, etc. 

Some of the hottest property types for cost seg today include:  

• Garden-Style Multifamily Apartment Complexes
• Industrial/Manufacturing Facilities
• Auto Dealerships
• Self-Storage Facilities
• Triple Net Lease Properties

Cost segregation can even be performed on not-for-profit tenants in otherwise for-profit spaces, a trend we’re seeing quite a bit of lately.   

5. Does Cost Segregation Create New Deductions?  

Moving assets into shorter-lived categories doesn’t generate new deductions, rather it accelerates the deductions to an earlier point of the lifecycle of the asset ownership. By doing this, the taxpayer gets the depreciation benefit sooner, taking advantage of the time-value of money.   

6. When Is the Best Time to Perform a Cost Segregation Study? 

Ideally, it’s best to perform a cost segregation study immediately after a property is placed-in-service. This way, the engineer performing the site tour can get the most accurate picture of the items included within the property and can determine exactly which assets are present at the date placed-in-service. In addition, doing the cost segregation study at the time the assets are placed in service allows the taxpayer to maximize tax savings from day one.  

How Far Back You Can do a Cost Segregation Study  

The IRS does, however, allow the benefits from previous years to be claimed using a “look-back” cost segregation study. By reclassifying assets to their correct lives, taxpayers can “catch-up” on all the depreciation they would have received had the study been performed on day one. Look-back studies do not require an amended tax return; instead, the catch-up depreciation is claimed by use of Form 3115.  

7. Can I Use Cost Segregation as a Planning Tool?  

Absolutely. Even before a closing or development begins, taxpayers can plan out their tax strategy with cost segregation in mind. This can be done by designing the buildout maximizing costs in areas that would be eligible for accelerated depreciation when possible, or by running an analysis to match the depreciation deductions with the cash laid out at closing to balance their cash flow. The taxpayer might also consider incorporating energy-efficient features into the design, teeing up future IRC Sec. 179D Deductions or IRC Sec. 45L Credits.  

In addition, when a study is complete, the included unit of property data will lay the groundwork for future tax savings opportunities, especially if future capital expenditures are on the horizon.

8. What Is Bonus Depreciation? How Is it Connected to Cost Segregation?   

Bonus depreciation permits the additional write-off of an eligible asset’s value in addition to standard depreciation. New assets with class lives of less than 20 years are eligible for this “bonus,” which significantly boosts tax savings. The Tax Cuts for Jobs Act (“TCJA”) allows bonus depreciation to be taken on used assets placed-in-service on or after September 28, 2017. Cost segregation is an effective tool used to determine and document which assets have eligible class lives and are therefore eligible for this powerful incentive.   

The bonus depreciation rate is 100% for eligible assets placed-in-service between September 28, 2017  and December 31, 2022. The rate has decreased to 80% for projects placed-in-service in 2023 and will continue to decline by 20% annually through 2026.   

Cost segregation studies still bring great benefit, even at lower bonus rates.   

9. Is Cost Segregation Only Useful for Newly Constructed or Acquired Properties? Can I Use Cost Segregation Before a Major Renovation? 

It’s true that cost segregation is a great tax strategy to use on newly constructed or acquired properties, or those constructed or acquired several years ago.

However, impending renovations are also an excellent cost segregation trigger. It might seem counterintuitive to perform a detailed study of assets that you plan to dispose of, but quantifying these assets through a cost segregation study before they are retired provides the data to take advantage of a strategy called partial asset disposition (PAD) election.  PAD elections permit a taxpayer to write off the remaining depreciable basis of an asset that was disposed of in the year it was removed. This can be an incredible tax-savings strategy, but requires a complete record of the assets in question.   

Additionally, recent changes in the tax regulations allow for significant accelerated depreciation if the renovations are considered Qualified Improvement Property (“QIP”).  

10. What Is Qualified Improvement Property? How Is it Connected to Cost Segregation?  

QIP is defined as improvement made by the taxpayer to an interior portion of a nonresidential building placed in service after the date the building was originally placed in service. The only items that would not qualify for QIP would be expenditures attributable to the enlargement of the building, elevators or escalators, or the internal structural framework of the building. The CARES Act of 2020 assigned QIP a 15-year recovery period. By assigning QIP a class-life of less than 20 years, the CARES Act made QIP bonus-eligible for taxpayers. (It should be noted that if the taxpayer is electing as a real property trade or business, QIP will not be bonus-eligible).  

A cost segregation study is the key to this incentive as well, as it provides the comprehensive data required to categorize eligible assets and assign appropriate cost values. This is a major advantage to nonresidential owners as this would allow taxpayers who provide tenant buildout allowances an opportunity to accelerate the depreciation of these assets. 

Ready to Optimize Your Real Estate Tax Strategy?  

Reach out to our team of seasoned professionals to start your cost segregation study strategy today.