Real estate property ownership requires proactively managing costs to optimize cash flow and maximize long-term investment returns.
As an owner looking to run your property as lean as possible, a cost segregation study can greatly reduce your tax liability, maximize tax savings, and improve cash flow.
In today’s guide, we explore the process and benefits of a cost segregation study as well as how you can choose the best firm to conduct the study for you.
Finding the best firm can be overwhelming, given the many options available. At Seneca Cost Segregation, we can help you maximize your tax savings for different types of properties.
All our studies get approved by the IRS since we follow its guidelines on creating legal and defensible studies.
Schedule a free consultation with us to see if your property qualifies for cost segregation and how much you can save.
What is a Cost Segregation Study?
A cost segregation study is a legal analysis of a property that allows real estate owners to lower their tax burden through accelerated depreciation.
Through cost segregation, you can accelerate depreciation for various qualifying components of your property over a five-, seven-, or fifteen-year schedule instead of the usual straight-line schedule of 39 or 27.5 years.
A cost segregation study is necessary because the Internal Revenue Service (IRS) considers your whole property a singular unit.
The service takes the property’s construction or purchase price (minus the land cost) and calculates its depreciation by dividing the value by 27.5 for residential rental property or 39 years for non-residential property.
As such, your first-year depreciation deduction becomes the same as the final year’s deduction.
However, with cost segregation, you can front-load the depreciation deductions to minimize your tax liability in the first several years of the property’s life.
Who Can Do a Cost Segregation Study?
As a highly complex process, a cost segregation study requires unique expertise and experience. Here’s who can conduct the study:
- Degreed and experienced engineers with construction, tax law, and accounting knowledge. These engineers are called cost segregation engineers.
- Cost segregation consultants with engineering expertise and experience, such as tax experts and Certified Public Accountants (CPAs).
- Certified Cost Segregation Professionals (CCSPs) with expertise in construction principles, taxation, and IRS cost segregation guidelines.
- Cost segregation companies or firms (like ours), which specialize in cost segregation and hire in-house accountants, engineers, and tax experts.
Quick Note: Vetted and certified by the American Society of Cost Segregation Professionals (ASCSP), CCSPs aren’t always CPAs or engineers but know how to use and apply cost segregation methods.
You can also do your own cost segregation study if you have expertise and experience in engineering, taxation, construction, and accounting.
However, you would be better off letting a professional firm or individual handle it for you to ensure maximum objectivity.
When Can You Do a Cost Segregation Study?
You’ll want to get the timing for the study right to optimize the benefits of the cost segregation tax strategy. Consider timing your study as indicated below:
- Immediately after buying a property or during the year you buy it
- Immediately after constructing a property or during the year you build it
- Following a substantial expansion, remodelling, or renovation of a property
- Retroactively on older property that has been operational for years, if it qualifies
- Immediately after placing a property in service (putting it to its intended use) or during the year you do so
While the timing of a cost segregation study is crucial for leveraging the time value of money, you should proceed with it if you plan on holding the property for at least five years.
Cost Segregation Study Benefits
Now that you know what a cost segregation study is, who can do it, and when, let’s check out some benefits you can enjoy from the practice:
- Reduced Tax Burden: The study helps you reclassify various property components that qualify for accelerated depreciation, reducing your taxable income. You enjoy lower tax payments each year you leverage the practice.
- Increased Cash Flow: Accelerated depreciation allows you to deduct more in the early years of a property’s life, improving your cash flow and easing short-term burdens.
- Reduced Operational Costs: A cost segregation study can identify improvement areas where you can manage and maintain your property more efficiently, reducing operating costs over time.
- Maximizing Overall Return on Investment: A lower tax liability can mean a higher long-term return on investment.
- Opportunities for Growing Your Portfolio: You can plough back the tax savings to grow your real estate portfolio by investing in new properties.
The Process of Conducting a Cost Segregation Study
To perform a defensible and accurate cost segregation study, you and your cost segregation company should follow these steps:
1. Collect Property and Component Information: You should gather documents and information such as:
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- Appraisal reports
- Lease agreements
- Purchase agreement and closing statement
- Tax returns if the property is already in service
- Maintenance records, utility bills, and operational expenses
- Construction records, if available, including contracts
- Details of improvements, expansions, or renovations
- Land value allocation
- Inspection reports
- and more, as available or required.
2. Conducting a Feasibility Evaluation: Your firm should conduct a preliminary cost segregation analysis to determine whether your property is eligible. It should also estimate the property’s potential tax savings to decide whether or not they can offset the cost of the study.
3. Analyze the Property: Once the firm proves that the study will be worthwhile, it inspects the property virtually or on-site to identify, value, and categorize components into 5-, 7-, or 15-year accelerated depreciation schedules.
4. Assigning Costs: The firm calculates the accelerated depreciation deductions for the qualifying component parts.
5. Determining Tax Savings: The experts calculate the tax savings due to cost segregation accelerated depreciation, collectively for all the eligible components.
6. Creating a Report: In this final step, your cost segregation study company creates a comprehensive report that explains its approach, calculations, findings, and recommended tax deductions.
Once these steps are completed, you can file the report with the IRS to claim the recommended tax benefits.
While we mention that you can do a cost segregation study yourself, the process can be overwhelming, even if you have the necessary expertise. You must also maintain high levels of objectivity.
The best you can do is hire a cost segregation company to help you. At Seneca Cost Segregation, we maximize your tax savings through IRS-compliant cost segregation studies.
We haven’t had any of our thousands of completed studies audited by the IRS. In the case your study is audited, we offer post-study support where we defend it for you. You may qualify for our money-back guarantee!
Consult with us for free to find out how much you can save through cost segregation depreciation.
The Role of Bonus Depreciation in Cost Segregation
Although it’s being phased out, bonus depreciation is another great tax planning strategy for property owners.
The incentive lets you deduct a significant part of the cost of a property through eligible components in the year the property is placed in service.
The bonus depreciation rate was reduced to 80% in 2023 and will be reduced annually by 20% until it is finally phased out by the end of 2026.
The timeline for the incentive is as follows:
- Year 2022: 100% bonus depreciation
- 2023: 80% bonus depreciation
- 2024: 60% bonus depreciation
- 2025: 40% bonus depreciation
- 2026: 20% bonus depreciation
- 2027: Bonus depreciation is phased out entirely unless extended or modified.
You should also consider these other critical aspects of bonus depreciation:
- The incentive offers the same benefits as cost segregation, including reduced tax liability, improved cash flow, and reinvestment opportunities.
- Cost segregation and bonus depreciation go together since claiming the latter involves doing a cost segregation study.
- Bonus depreciation can apply to both acquired and constructed properties with a useful life of 20 years or fewer, among other qualifications.
Let’s have a quick example to illustrate the amplifying impact of bonus depreciation on cost segregation:
Assuming you placed a property worth $1,000,000 in service in 2022. Your cost segregation study found that $300,000 of the property qualifies for bonus depreciation.
Since you placed the property in service in 2022, the entire $300,000 will be written off in the first year.
If you had placed it in service in 2023, only $240,000 (80% of $300,000) would be written off in the first year. The remaining 20% of the 5- and 15-year property depreciation would trickle in over the next 5 and 15 years, respectively.
How to Choose the Right Cost Segregation Services
Here’s what to consider to choose the right cost segregation service:
- Team Composition: An effective cost segregation team should have a unique blend of engineers with accounting, tax law, and construction expertise and experience. Look for years of experience, and whether they use in-house engineers or hired contractors.
- Experience in Studies in Your Industry or Property Type: Ensure they have completed studies in your sector and type of property. Some common industries include healthcare, hospitality, residential, and manufacturing.
- Audit Defense: Ensure the provider is willing to defend their study if the IRS audits you.
- Check Reviews and Testimonials: The firm should be willing to share credible reviews and testimonials from past clients. Look for recommendations about their professionalism, thoroughness, customer service, and track record of IRS-compliant studies. See if you can also get highlights of actualized tax savings and ROI from the study.
Common Mistakes to Avoid in Cost Segregation Studies
Cost segregation studies can be tricky, especially if you are doing one for the first time. You’ll want to be on the lookout for mistakes such as:
- Inadequate Records: Poor documentation and recording can lead to an audit that could cause penalties, fines, or rejected deductions. You must maintain detailed property records and have your team generate a thorough study report.
- Misclassifying Assets: If the team misclassifies components, you’ll have incorrect depreciation schedules. You could get audited for overstating or understating deductions. Ensure your firm strictly follows IRS guidelines on classification.
- Not Partnering with Qualified Professionals: As mentioned, you can do the study alone, but you might struggle with objectivity. You should use experts to avoid subjectivity and reduce the chances of an audit.
With the right service, you can avoid these mistakes and potential IRS audits. We at Seneca Cost Segregation conduct studies using the IRS Audit Techniques Guide, ensuring compliance.
Through our streamlined three-step process, we’ll help you legally reduce your taxable income to maximize your tax savings and improve cash flow.
We can help you take advantage of cost segregation in all 50 states.
Lower your tax bill with a cost segregation study—get started with Seneca cost segregation services today.
Frequently Asked Questions (FAQs)
We’ll end today’s discussion with a few questions about cost segregation studies:
What Does a Cost Segregation Engineer Do?
The primary goal of a cost segregation engineer is to identify and reclassify all property components depreciable over a shorter period of fifteen, seven, or five years.
The engineer then assigns costs to these qualifying assets, calculates the potential tax savings, and prepares a comprehensive cost segregation report.
What Are the Penalties for Incorrect Cost Segregation Reporting?
The penalties for inaccurate information or overuse of cost segregation include:
- A 20% penalty on any tax underpayment due to a substantial valuation overstatement, as imposed by IRC Section 6662(a).
- A $1,000 penalty on anyone who aids and abets an understatement of another’s tax liability, as imposed by Code Section 6701. (The penalty is $10,000 if it’s a corporation.)
Is a Cost Segregation Study Worth It for Small Properties?
A cost segregation study is worth it for small properties. If you are concerned about its worth, you can reach out to us for a savings and ROI estimate.
We’ll let you know how much you can save and the return on investment in the study.
What Industries Benefit Most From Cost Segregation?
Nearly all industries can benefit from cost segregation studies. You may experience higher benefits in:
- Healthcare and medical facilities (hospitals, nursing homes, and medical offices)
- Industrial real estate (distribution centers, warehouses, and manufacturing facilities)
- Retail facilities (shopping centers, grocery stores, and malls)
- Hospitality industry (hotels and resorts)
- Oil and gas (gas stations)
- Self-storage facilities
- Mobile home parks
Conclusion
If your real estate property is eligible, conducting a cost segregation study can lighten your tax burden, maximize your overall return on investment, and increase cash flow.
However, the complexity of the process requires special expertise and experience, which you may not have. You’ll want to work with the right firm to deliver an IRS-ready study that can withstand a potential audit.
When you work with us at Seneca Cost Segregation, we guarantee an audit that the IRS will approve without the risk of an audit.
We also use our expertise and experience to uncover the best classifications to maximize your tax savings, increasing your cash flow and reinvestment finances.
Get a free tax savings estimate to see how much you can save.
