Cost Segregation: A Great Strategy When?

One of the standout tax advantages of owning residential rental properties or commercial or investment properties is the ability to utilize depreciation as a deduction. This deduction is particularly notable because it requires no additional cash outlay.

Introduction to Cost Segregation

Cost segregation is a strategic tax planning tool that allows property owners to accelerate depreciation deductions and maximize tax benefits.

What is Cost Segregation?

Cost segregation involves identifying and reclassifying certain assets within a property to shorter depreciation periods. By separating personal property assets and land improvements from real property, property owners can depreciate these assets over shorter periods, resulting in increased tax deductions.

How Does Cost Segregation Work?

During a cost segregation study, qualified professionals analyze the components of a property to determine which assets qualify for accelerated depreciation. This analysis includes identifying items such as land improvements (e.g., landscaping, parking lots) and personal property items (e.g., appliances, fixtures) that can be depreciated over shorter periods.

Significance for Property Owners

Cost segregation offers significant tax advantages for property owners, particularly in the initial years of ownership. By accelerating depreciation deductions, property owners can reduce their taxable income and improve cash flow. This can lead to substantial tax savings and increased profitability over the life of the property.

More Detail on Depreciation and Cost Segregation

Depreciation allows property owners to write off the property’s value over a set period. However, the standard depreciation schedules for real property can feel quite protracted. For residential rental properties, the depreciation period extends over 27.5 years, while non-residential properties are depreciated over 39 years. This method results in a relatively modest annual deduction, which may not seem significant in the short term.

Fortunately, property owners have a method to accelerate these depreciation deductions, particularly in the initial years of ownership: this method is known as cost segregation. Cost segregation is a strategic tax practice that involves identifying and separating personal property assets and land improvements from real property. These assets are not considered part of the land, the building structure, or integral components.

Examples of such assets include, but are not limited to, land improvements like landscaping, swimming pools, paved parking areas, and fencing. Inside the buildings, personal property items that can be segregated include appliances like refrigerators and stoves and fixtures such as carpeting in residential rentals.

Benefits

The primary benefit of using cost segregation is not that it increases the total depreciation a property owner can claim but rather significantly accelerates these deductions. This is because personal property and land improvements are depreciated over much shorter periods—typically five or seven years for personal property and 15 years for land improvements.

Property owners can also enhance their tax savings in the first year of ownership by taking advantage of bonus depreciation and/or Section 179 expensing. These provisions allow for the immediate deduction of most if not all, costs associated with personal property and land improvements in the year they are purchased. This can result in a substantial deduction in the first year, dramatically affecting a property owner’s taxable income.

The optimal time to conduct a cost segregation study is ideally the same year the property is purchased, constructed, or substantially renovated. However, deferring this study to a later year is possible if it better aligns with the owner’s financial situation—such as when they have substantial rental or other passive income that could benefit from the accelerated depreciation deductions. This strategic timing can maximize the economic benefits and help manage tax liabilities more effectively.

Identifying Assets Eligible for Segregation

Cost segregation involves identifying specific assets within a property that qualify for accelerated depreciation. These assets can be found both inside and outside of buildings, and they include a variety of components that may not be immediately apparent.

Inside the Building

Personal Property Items:

• Appliances: Refrigerators, stoves, dishwashers, microwaves.
• Fixtures: Carpets, window treatments, light fixtures, built-in cabinetry.
• Furniture: Desks, chairs, tables, shelving units.
• Equipment: Computers, printers, security systems.

Specialized Building Components:

• HVAC Systems: Heating, ventilation, and air conditioning equipment.
• Electrical Systems: Wiring, switches, outlets, lighting controls.
• Plumbing Systems: Pipes, faucets, water heaters, plumbing fixtures.

Interior Finishes:

• Flooring: Carpeting, tile, hardwood flooring.
• Wall Finishes: Paint, wallpaper, paneling.
• Ceiling Finishes: Suspended ceilings and ceiling tiles.

Outside the Building

Land Improvements:

• Landscaping: Trees, shrubs, flowers, grass, irrigation systems.
• Paved Surfaces: Parking lots, sidewalks, driveways.
• Site Improvements: Fencing, retaining walls, signage.

Utility Systems:

• Utility Lines: Water lines, sewer lines, gas lines.
• Lighting Systems: Exterior lighting fixtures, streetlights.

Miscellaneous Assets:

• Outdoor Fixtures: Benches, picnic tables, playground equipment.
• Recreational Facilities: Swimming pools, tennis courts, sports fields.

Examples of Commonly Segregated Assets

• Landscaping and Hardscaping: Land improvements such as landscaping, paved surfaces, and fencing are often segregated for accelerated depreciation.
• Appliances and Fixtures: Personal property items like refrigerators, stoves, carpets, and light fixtures qualify for shorter depreciation periods.
• HVAC and Electrical Systems: Components of the building’s mechanical and electrical systems, including HVAC units and wiring, can be segregated.
• Specialized Equipment: Specialized equipment used in the building, such as security systems or specialized manufacturing equipment, may also qualify.

Identifying these assets and properly segregating them through a cost segregation study can result in significant tax savings for property owners by accelerating depreciation deductions and maximizing tax benefits.

Maximizing Tax Savings

Property owners can further enhance their tax savings by leveraging additional tax strategies in conjunction with cost segregation. Two key strategies are bonus depreciation and Section 179 expensing.

Bonus Depreciation

• Overview: Bonus depreciation allows property owners to deduct a significant portion of the cost of qualifying assets in the year they are placed in service.
• Benefits: Property owners can immediately deduct up to 100% of the cost of eligible assets, including those identified through cost segregation.
• Eligibility: Bonus depreciation also applies to new and used tangible property with a recovery period of 20 years or less, including qualified improvement property (QIP).
• Impact: When combined with cost segregation, bonus depreciation can result in substantial deductions in the first year of ownership, reducing taxable income and improving cash flow.

Section 179 Expensing

• Overview: Section 179 of the IRS tax code allows property owners to deduct the full cost of qualifying assets in the year they are placed in service rather than depreciating them over time.
• Benefits: Property owners can also immediately expense up to a certain dollar limit ($1,050,000 in 2021) of qualifying property, including assets identified through cost segregation.
• Eligibility: Section 179 expensing applies to tangible personal property used in the business, including equipment, furniture, and certain improvements to non-residential real property.
• Impact: Like bonus depreciation, Section 179 expensing can result in significant reductions in the first year of ownership when combined with cost segregation, providing immediate tax relief and improving cash flow.

Combining Strategies for Maximum Benefit

• By combining cost segregation with bonus depreciation and Section 179 expensing, property owners can thus maximize their tax savings in the first year of ownership.
• This powerful combination allows property owners to accelerate depreciation deductions for qualified assets, reducing taxable income and lowering tax liabilities.
• Property owners should work closely with tax professionals or cost segregation specialists to optimize their tax strategies and ensure compliance with IRS regulations.

Optimal Timing for Cost Segregation

Moreover, conducting a cost segregation study at the right time is crucial for maximizing its benefits and tax savings. Here are considerations for determining the optimal timing for a cost segregation study:

Conducting the Study at Property Acquisition or Construction

• Immediate Impact: Conducting a cost segregation study at the time of property acquisition or construction allows property owners to identify and segregate eligible assets immediately.
• Maximized Deductions: By identifying assets early in the property’s life, property owners can maximize depreciation deductions from the outset, resulting in significant tax savings.
• Alignment with Purchase Price: The study can also be used to allocate the purchase price or construction costs among different asset classes, optimizing tax benefits.

Substantial Renovation or Improvement Projects

• Opportunity for Reassessment: Substantial renovation or improvement projects present an opportunity to reassess the property’s assets and identify additional eligible items for segregation.
• Enhanced Tax Savings: During renovation, owners can also reclaim missed deductions, enhancing future tax savings through cost segregation.

Reasons for Deferring a Cost Segregation Study

1. Financial Constraints: Owners might delay cost segregation due to insufficient upfront funds for the study. However, deferring the study may result in missed tax savings opportunities in the short term.
2. Limited Tax Liability: Owners may delay cost segregation until tax liabilities rise due to limited early liability. However, delaying the study may postpone tax savings and cash flow benefits.
3. Changes in Ownership Structure: Changes in ownership or imminent property sale justify postponing a cost segregation study. Property owners may prefer to conduct the study closer to the time of sale to maximize tax benefits for the new owner.
4. Strategic Planning: Property owners may strategically defer a cost segregation study to align with future tax planning goals or to optimize tax benefits in specific years based on income projections or changes in tax laws.

Conclusion

In conclusion, cost segregation is a potent tax-saving method, speeding up depreciation deductions and maximizing tax advantages. Property owners can significantly reduce taxable income, improve cash flow, and enhance overall profitability by identifying and segregating eligible assets. Cost segregation offers immediate tax relief and long-term financial benefits for property owners. Therefore, Property owners should consider cost segregation to maximize tax benefits and achieve financial goals efficiently.