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Cost Segregation for Commercial Real Estate

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  • Cost Segregation for Commercial Real Estate

    Hi Everyone. Does anyone have experience using "cost segregation" to accelerate the depreciation on their practice owned office building and thus increase cash flow and decrease taxes owed. A company approached one of my partners (flyer attached) and while I am just a neophyte when it comes to commercial real estate, my initial instinct is that there is a catch somewhere in there. I'd be curious to hear others thoughts and experience with this. Thanks so much.


  • #2
    Cost segregation studies are legitimate tax savings tools.  There was a landmark court case on the topic that allows this approach.  The idea is that you separate components of a building into assets that are depreciated over a shorter time frame.  Commercial real estate is depreciated over 39 years (excluding the land which is non-depreciable).

    But personal property (equipment, machinery, computers, etc.) is depreciated over a shorter period of time (3, 5, or 7 years) and may even be allowed to be fully expensed in the first year placed into service.

    The benefit of a cost segregation is accelerating the depreciation expense into earlier years.  You don't get more total depreciation, just more sooner.

    There are some down sides though.  If you want to do a §1031 exchange when you sell the building the personal property you segregated out isn't eligible for the exchange.  You'll be paying taxes on the gain related to the sale of the personal property if you allocate any of the sale price to those assets.

    If you sell and don't do an exchange your gain will be larger than it would have been had you not done the cost segregation study.  But you also got the deductions in earlier years.

    Whether you do one or not takes into account your current marginal tax rates and your future ones much like the decision to do traditional or Roth contributions.  A deduction is more valuable in a tax year when your marginal rate is higher and income is taxed less when your marginal rate is lower.

    I've seen many clients do these with success.  You usually get a very thick report at the end that the IRS would have a hard time challenging.


    • #3
      Of course, the cost segregation also makes the depreciation schedule much more detailed, but I suppose that just will be more work for your accountant (and slightly higher prep fees for your partnership). And don’t forget that higher depreciation leads to increased depreciation recapture if you plan to sell, though again this is less a concern if you intend a series of tax deferred exchanges over time. All in all, the balance favors using the cost segregation approach to reduce taxes in the near term.


      • #4
        I used to know a guy who "sold" these analyses but I never could get into it. Kind of costly and you're just accelerating depreciation which will lower the future deductions. I know that is an oversimplification but the level of detail for depreciating components of a building that are going to be depreciated in the future just doesn't appeal to me. I've looked at it with clients and they've given it a pass, too. With today's lower tax rates, it makes even less sense to me. But they do have slick marketing materials.

        Guessing my client bases is very different from that of DavidGlennCPA, though.
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        • #5
          Cost segregation study provides much larger upfront deduction, which is a passive loss from personal tax perspective. You have to make sure you have substantial passive income or able to deduct passive loss against active income to take advantage of it.  If you can then I would definitely recommend to do it (I did several studies and got a nice tax savings out of it, but then I have tons of passive income to write off against).

          Cost segregation studies are completely legal. Go with a reputable company - they have to do a site visit and use engineer to break down building into its components and also offer free defense against IRS inquiry. Study will give you a nice itemized list of building components grouped based on its depreciation schedule. Cost seg will give you on average of 20-30% of building price as additional depreciation so tax savings could be pretty substantial.

          To make the study work for you even better, plan to sell building when your income tax bracket is significantly lower, or never sell. Also consider replacing building items outlined in cost segregation study as they wear out.


          • #6
            Yes they work great, especially for commercial properties. These properties have a useful life of 39 years. So if you can lessen that you will find a nice benefit. But be careful because many studies will cost you $5k to $10k. So they typically only make sense on larger properties.
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