Should you always do a cost segregation study?

By Kory Reynolds August 7, 2024

Deciding to do a cost segregation study depends on a variety of factors and there is no one-size-fits-all answer. Each project must be evaluated individually and in the context of the taxpayer’s full situation. It is important to discuss the benefits and limitations with your tax advisor, taking into consideration your future plans and current circumstances.

A quick refresher

Cost segregation studies are a strategic tax planning tool for real estate owners and other industry professionals. A cost segregation study analyzes building costs and identifies specific components that qualify for shorter federal tax lives than the building as a whole. Cost segregation studies most commonly are done when taxpayers either acquire or construct new property or complete substantial renovations or expansions on an existing property.

What are the benefits of a cost segregation study?

You may already understand that cost segregation allows you to accelerate depreciation on constructed or acquired real property. So, instead of writing the entire building off over 27.5 years, you can write off (for example) 15% over 5 years, 5% over 7 years, 5% over 15 years, and the remaining 75% over 27.5 years.

By the time you have owned the residential building for 27.5 years, you will have claimed the same depreciation over the life of the building; the cost segregation study just allows you to accelerate a significant portion of that depreciation to the first few years and even more so with bonus depreciation. The acceleration of this depreciation can generate paper losses, that a taxpayer could potentially use to offset other sources of income, such as income from an operating business, wages, other rental properties, retirement distributions, or income from traditional brokerage investments. Bonus depreciation magnifies this by allowing a large portion of short-life assets – meaning less than a 20-year tax life – can be written off in the first year that property is placed in service.

What should you consider before doing a cost segregation study?

Before you embark on a cost segregation study, consider these key factors and discuss their potential implications with your tax advisor:

How much will it cost?

Cost segregation studies are not free. In my experience serving clients, prices can range from $4,000 – $19,000, depending on the type of property. Remember, this is an acceleration of the depreciation; you are accelerating depreciation deductions to the first few years of the project’s life, which will result in less depreciation expense in later years. This means that implementation of a cost segregation study is a time value of money benefit – paying less tax now to potentially pay more taxes later. Therefore, when considering the tax benefits of the study, it is important to consider both the cost of the study itself and the cost of your tax team to implement the study into your tax filings; you need to make an investment decision based on whether those tax savings are worth the related professional fees for a given project.

What is your hold period?

If you have a relatively short hold period, you will experience depreciation recapture on all accelerated depreciation upon the sale. This substantially offsets the time value of money benefit. For example, would you pay $8,000 to save $50k in tax this year, only to pay that $50k in tax next year when you sell? That is a pricey interest rate!

Can you use the losses?

Are you a material participant or a real estate professional under the tax code?  When you consider whether you can use the losses created by a cost segregation study, you need to consider what “bucket” of income the activity is in, and what “bucket” of income you are trying to offset. For example, if your investment in the real estate is deemed passive, you won’t be able to use those losses to offset non-passive sources of income, such as wages or self-employment income, and you also can’t use those losses to offset investment income, such as from a brokerage account.  You could, however, use those passive losses to offset other sources of passive income. It is also worth discussing with your tax professional whether you would be deemed a material participant or real estate professional under the tax code, which may allow you to use these losses against all other sources of income, regardless of which “bucket” the income is in.

Can you use the losses in X years?

If you are passive now but plan on becoming a qualified real estate professional in a couple of years, it might be worth waiting to do the study until you are a qualified real estate professional. This would allow you to use the losses with a change in accounting method. Similarly, consider if this would create excessive trapped losses if you plan on making the REPS election in a future year.

What tax rates?

Sometimes, you are already at a low effective tax rate, and the cost segregation firm’s time value modeling is typically at maximum tax rates. If you are only saving at a 12% tax rate, consider waiting or working with your tax team to put together a time value calculation to help you evaluate if the cost of the study is worth the tax savings, or if it may be better tax planning to implement a study in a future year.

What is the benefit to your partners?

If you have partners in a deal, then they must be considered. Are they passive with no other passive sources to offset these losses? Are they passive with other sources of passive activity to offset? If the latter is the case, those losses may be disallowed for that investor, and carried forward to future years until that property is disposed of, or to offset future sources of passive income.  In the case where the passive investor won’t be able to use the losses for a number of years, then there may be very little, or no, benefit for a cost segregation study to be implemented.

These are just a few tips and considerations to help determine whether a cost segregation study is right for you. Assessing your goals and situation is important to making the right choice. Talk to your tax advisor and get their feedback about whether and how you may benefit from a study, or if there are other strategies you should consider.

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