Cost Segregation

Cost segregation is a tax planning strategy used by businesses and real estate investors in the United States to accelerate depreciation deductions on certain assets, typically real estate properties. It involves segregating and reclassifying the costs of a property into shorter recovery periods for tax purposes. This allows taxpayers to reduce their current taxable income and, consequently, their tax liability, resulting in increased cash flow.
Here's how cost segregation works:

Asset Identification: A cost segregation study begins by identifying the various components or assets within a property. These assets can include not only the building itself but also its structural components, interior finishes, and any additional improvements like landscaping, parking lots, or security systems.
Asset Classification: Once identified, these assets are classified into specific categories based on their recovery periods for tax depreciation purposes. The IRS provides guidelines and classifications for various assets in its tax code.
- Real Property: Components that are typically classified as real property have longer depreciation periods (e.g., 27.5 years for residential rental properties and 39 years for commercial properties).
- Personal Property: Components that can be reclassified as personal property may have shorter depreciation periods (e.g., 5, 7, or 15 years). This includes items like lighting fixtures, carpeting, and specialized electrical systems.
Cost Allocation: The next step involves allocating the total cost of the property to these different asset categories. This is done based on a detailed analysis of construction records, invoices, and other relevant documentation.
Depreciation Adjustment: With the cost allocated to shorter-lived assets, taxpayers can then depreciate these assets at a faster rate than the building itself. This results in higher depreciation deductions in the early years of ownership, reducing taxable income and tax liability.
Tax Savings: The immediate tax savings generated by cost segregation can be substantial, as it allows property owners to take advantage of front-loaded depreciation deductions. These savings can be reinvested or used to offset other income, helping to improve cash flow and the overall return on investment.

It's important to note that cost segregation studies should be conducted by professionals with expertise in engineering, construction, and tax regulations to ensure compliance with IRS guidelines and to withstand potential audits. While cost segregation can provide significant tax benefits, it may not be suitable for all real estate properties or investment strategies, so it's essential to assess its potential advantages in the context of your specific situation and consult with tax experts and financial advisors.

Fortunately, Meritum Consulting's experts hold numerous engineering degrees, have more than two decades of experience in the Cost Segregation industry, and are members of the ASCSP (American Society of Cost Segregation Professionals).