Cost Segregation Study
A cost segregation study is an engineering-based tax analysis that identifies and reclassifies components of a commercial or investment property from long-lived real property — depreciated over 27.5 or 39 years — to shorter-lived personal property or land improvements depreciated over 5, 7, or 15 years, accelerating depreciation deductions.
When a taxpayer acquires or constructs a commercial or investment building, the default IRS rules require depreciating the structure over 39 years for commercial property or 27.5 years for residential rental property. A cost segregation study allows the property owner to identify specific building components that qualify for much faster depreciation under different asset classes.
The study is performed by a team that typically includes engineers, architects, and tax professionals who physically inspect the property and review construction cost records. They identify components that qualify as five-year property (carpeting, certain fixtures, and equipment), seven-year property (office furniture and certain fixtures), or fifteen-year property (land improvements such as parking lots, sidewalks, and landscaping). These components can then be depreciated on an accelerated schedule rather than over the full life of the building.
The financial benefit is front-loading depreciation deductions into the early years of ownership when they have the greatest present value. Combined with bonus depreciation, which allows a portion or all of the qualifying shorter-lived assets to be fully expensed in the year placed in service, cost segregation can generate very large depreciation deductions in year one for a property acquisition.
Real estate professionals who meet the IRS definition — spending more than half their working hours and at least 750 hours per year in real property trades or businesses — may be able to use these accelerated deductions against non-passive income, providing a direct reduction in their overall tax liability.
Upon sale of the property, depreciation recapture rules require previously deducted depreciation to be taxed at recapture rates (up to 25 percent for real property depreciation), so cost segregation shifts rather than eliminates the tax. Planning for this recapture is an important part of any cost segregation strategy.