The Value of Cost Segregation Studies
These tools can help CRE professionals leverage tax laws to reduce asset liabilities.
Cost segregation studies should be in the back pocket of every commercial real estate investor. When optimized, they can increase cash flows, reduce tax liability, and uncover missed deductions. Now, thanks to the Tax Cuts and Jobs Act of 2017, the benefits are more favorable than ever.
A cost segregation study is a strategic planning tool that can assess an entity's real property assets and identify a portion of those costs that can be treated as personal property. By identifying personal property to be segregated from the building, the studies can reassign costs that would depreciate over a 39-year period to asset groups that depreciate more quickly or perhaps are even expensed immediately.
The tax reform package made two simple changes, both to bonus depreciation, that will make cost segregation studies more valuable. Bonus depreciation allows individuals and businesses to immediately deduct a certain percentage of their asset costs the first year they are placed in service. The tax law did two things: It made used property eligible for bonus treatment for the very first time and increased the bonus percentage to 100 percent through tax year 2022. Prior to this law change, only new property qualified, and bonus depreciation was expected to be only 50 percent in 2019.
Performing a cost segregation study will now have a stronger impact. Any assets that are removed from the real property bucket and placed in the personal property bucket may now be eligible for bonus depreciation and can be immediately expensed in the first year.
Consider this example: A taxpayer purchases a building worth $10 million. After performing a cost segregation study, she can reclassify 10 percent of those costs to be personal property. By assigning these assets a shorter depreciable life, she can apply bonus depreciation and write off $1 million of that $10 million purchase price in Year One. A taxpayer with a 25 percent marginal tax rate would save $250,000 in taxes, or 2.5 percent, that first year.
A cost segregation study may also come in handy during a renovation, although the reason why is somewhat convoluted. Back in 2015, before the Tax Cuts and Jobs Act, the Protecting Americans from Tax Hikes (PATH) Act was passed. This law removed the following three property classifications:
- Qualified leasehold improvement property,
- Qualified restaurant property, and
- Qualified retail improvement property.
In their place, it created an asset group called qualified improvement property. This new asset group included the same types of 15-year assets as the three groups it had replaced, but it also included certain non-structural improvement assets. Once this law was passed, building improvements like plumbing, ventilation systems, and alarm systems were treated as 15-year assets. This was great news for renovators; they could now depreciate these assets over a shorter, 15-year period.
When the Tax Cuts and Jobs Act was passed two years later, Congress's intent was to extend bonus depreciation to qualified improvement property. Unfortunately, the appropriate wording did not make it into the tax bill, and qualified improvement property took a major hit. Not only did it never become eligible for bonus depreciation, it reverted to 39-year property. While we are still hoping for a technical correction, qualified improvement property is currently no better off than real property.
A cost segregation study is a strategic planning tool that can assess an entity's real property assets and identify a portion of those costs that can be treated as personal property.
While renovators may feel like they got the short end of the stick, they can still benefit from a cost segregation study. The purpose of their study should be to identify which assets are not qualified improvement property so that they can depreciate those assets over a three-, five-, or seven-year period and qualify for bonus depreciation.
All taxpayers in the commercial real estate industry - contractors, renovators, purchasers, and investors - may benefit from a cost segregation study to determine which property qualifies for accelerated depreciation. To help with the study, engage qualified professionals with expertise in this area like veteran engineers, quality CPA firms, and others holding the Certified Cost Segregation Professional designation. These professionals will help determine if the benefits will outweigh the costs.