By Kelly Berardi & Richard Hirschen
Gray, Gray & Gray, LLP

One of the most powerful yet underutilized tools in real estate tax strategy is the cost segregation study. When properly executed, these studies can significantly accelerate depreciation deductions and improve cash flow for property owners and investors.

Understanding Cost Segregation Fundamentals

Traditional depreciation methods typically treat commercial real estate as a single asset depreciated over 39 years, while residential rental properties are depreciated over 27.5 years. However, a cost segregation study involves analyzing and identifying building components that can be depreciated over shorter recovery periods – typically 5, 7, or 15 years. These components often include items such as carpeting, decorative lighting, landscaping, and specialized electrical or plumbing systems.

For example, in a recent study we conducted for a mixed-use development project, we identified approximately 35% of the building’s total cost as eligible for accelerated depreciation. This resulted in additional first-year depreciation deductions of $1.2 million for our client, generating substantial immediate tax savings.

Timing and Property Selection

The optimal time to conduct a cost segregation study is immediately after purchasing, constructing, or significantly renovating a property. However, property owners who haven’t previously utilized this strategy can still benefit from a look-back study, which allows them to claim missed depreciation from prior years without amending previous tax returns through a Section 481(a) adjustment.

When evaluating whether a property is suitable for cost segregation, we consider several key factors. Properties with a depreciable basis of at least $1 million typically offer the most favorable cost-benefit ratio. Additionally, properties with substantial recent improvements, unique architectural features, or specialized systems often yield better results. Our analysis shows that medical facilities, hotels, and manufacturing properties frequently provide the highest percentage of costs eligible for acceleration.

Integration with Other Tax Strategies

Cost segregation studies become even more powerful when integrated with other tax planning strategies. For instance, combining cost segregation with the Section 179 expense election and bonus depreciation can create substantial immediate write-offs. We recently helped a client utilize these combined strategies to deduct nearly 60% of their property’s purchase price in the first year of ownership.

Additionally, cost segregation studies can provide valuable information for future disposal strategies. When individual building components are properly identified and valued, property owners can more accurately calculate gains or losses when replacing or disposing of these components, potentially creating opportunities for loss harvesting.

Recent Changes

Cost segregation studies continue to be a valuable tax planning strategy, though recent changes have altered their benefits. The Tax Cuts and Jobs Act initially expanded bonus depreciation to 100% for qualified property placed in service after September 27, 2017. However, per the phase-out schedule, bonus depreciation decreased to 80% for property placed in service in 2023 and was further reduced to 60% in 2024. Unless Congress takes action to extend or modify these provisions, the rate will continue declining by 20% each year until it reaches 0% in 2027.

Despite these reductions, cost segregation studies remain important tools for property owners, as they can still accelerate depreciation and generate significant tax savings through both bonus depreciation and standard depreciation methods.

We’re also seeing emerging opportunities in sustainable building components and energy-efficient systems, which often qualify for accelerated depreciation and may be eligible for additional tax incentives. It is essential to stay current with evolving tax regulations and technical requirements to help identify and capture these opportunities.

Implementation and Follow-Through

Successful implementation of a cost segregation study requires ongoing attention to detail and proper integration with overall tax planning strategies. We provide our clients with detailed schedules and depreciation calculations that can be easily incorporated into their tax filings and future planning decisions. We also help clients establish systems for tracking and documenting future improvements to ensure continued optimization of depreciation benefits.

Cost segregation studies represent a powerful tool for real estate investors to improve cash flow and maximize tax benefits. Through careful planning, thorough execution, and integration with broader tax strategies, these studies can provide substantial returns on investment. Our firm’s extensive experience in this specialized area allows us to help clients navigate the complexities of cost segregation while maximizing their benefits within the framework of current tax law.