Exploring the Strategy Behind a Cost Segregation Study

The world of real estate tax strategies is complex. But one strategy is particularly impactful for real estate funds: obtaining a cost segregation study. These studies effectively allow real estate investors to pull forward tax savings by identifying components of their property that can be depreciated on a shorter timeline.

In recent years, cost segregation studies have been top of mind for many real estate investors. With bonus depreciation at 100% in the years after the passage of the Tax Cuts and Jobs Act, obtaining a cost segregation study often resulted in extremely attractive tax savings. Bonus depreciation has begun to phase out, dropping to 80% in 2023 and 60% in 2024.

These changes mean that the impact of a cost segregation study isn’t quite as immediate as it was before the reduction in bonus depreciation. However, that doesn’t mean these studies aren’t still an extremely valuable tool for real estate funds and investors.

Determining whether a cost segregation study is a fit for your portfolio demands you understand the overall strategy that drives the need for a study––or at the very least, work with a CPA who does. In this overview, we’ll explore the nuances behind the decision to obtain a cost segregation study so you can understand whether it might be a good fit for your portfolio.

Need a specialized real estate CPA with experience managing sophisticated tax strategies for your portfolio or want to understand whether you might benefit from a cost segregation study? Contact the James Moore Real Estate team today.

Cost Segregation Studies Explained

A cost segregation study splits real property into multiple depreciable categories. Instead of treating a real property as one entity, cost segregation studies break out the value of the property into individual components (roof, flooring, appliances, landscaping and so on).

Compared to real property as a whole, which is depreciated over 39 years (or 27.5 years for a residential property), these components can be depreciated much faster — over 5, 7, or 15 years, depending on the component.

This accelerated depreciation allows property owners to realize tax savings and increase cash flow from a property. Many types of real estate assets are eligible for a cost segregation study, including commercial buildings, multifamily buildings, rental real estate and more.

The impact of a cost segregation study is amplified by bonus depreciation. Bonus depreciation is scheduled to reduce from 60% in 2024 to 40% in 2025 and 20% in 2026, before being eliminated in 2027. The U.S. House of Representatives passed legislation in January 2024 that proposed extending 100% bonus depreciation through 2026. But as of this writing, this has yet to be taken up by the U.S. Senate.

To learn more about cost segregation studies, download our cost segregation infographic.

When Does a Cost Segregation Study Make Sense for Real Estate Funds? Key Factors

While it might seem like a straightforward decision to obtain a cost segregation study, there are many variables to consider. Below, we outline several important strategic considerations that real estate funds and investors should discuss with their tax advisors before obtaining a cost segregation study.

When Should A Real Estate Fund or Investor Obtain a Cost Segregation Study?

One of the first issues to consider is when it makes the most sense to realize the value of a cost segregation study. In many instances, the goal of a cost segregation study is to produce a tax loss that taxpayers can use to reduce their taxable income.

It’s important to note that this is considered a passive loss under passive activity rules. Investors can only use passive losses to offset passive income unless they are a real estate professional. If a real estate investor has little passive income, the losses produced by a cost segregation study might have little impact on their overall taxable income.

There’s also the question of timing. Investors can (and often do) obtain a cost segregation study in the year they acquire a property. Equally, however, investors can choose to have a cost segregation study at a later date. This enables investors to offset additional income, gains from the sale of a property, or after investing in improvements to a property.

What Tax Rate Are the Savings Being Used to Offset?

There’s also the question of the effective tax rate toward which an investor can apply the deductions from a cost segregation study.

Let’s say an investor sells a property, resulting in significant capital gains. To reduce this tax liability, the investor obtains a cost segregation study for another property in their portfolio, resulting in a tax loss that can be used to offset the capital gains. (It’s important to note that capital gains are taxed at 20%, whereas ordinary income is taxed as high as 37% at the top rate.)

In this scenario, allocating the tax savings from the cost segregation study to the gains may result in the investor making a less effective use of their deduction. It might be more favorable for investors to opt out of bonus depreciation on some components to lower their deductions from the study, pay taxes at the 20% capital gains rate, and use the deductions over the depreciable life of the asset to offset ordinary income taxed at the 37% rate.

Exploring the Cost-Benefit Analysis of a Cost Segregation Study

Cost segregation studies should be completed by specialized firms and can cost tens of thousands of dollars. Consider whether the juice is worth the squeeze: Does the accelerated depreciation that a cost segregation study produces represent incremental value above the cost of the study itself?

Generally, if a property was built, purchased or renovated in the last ten years and has a purchase or renovation price of more than $1,000,000, the answer is yes. However, every situation is different. Seek guidance from an experienced real estate tax professional to determine the best approach for your portfolio.

For real estate funds (which are tax neutral), the main benefit of securing a cost segregation study for the assets it manages lies in the benefits the accelerated depreciation offers investors.

Fund managers should aim to be clear with investors on the role of these deductions. Securing a cost segregation study only impacts the timing of the depreciation, not the amount. Together, cost segregation studies and bonus depreciation allow investors to front-load depreciation into the years immediately following the cost segregation study. As a consequence, there will be far less depreciation in future years. Investors may also be subject to depreciation recapture upon the sale of the property.

Build an Efficient Tax Strategy with James Moore: Real Estate CPAs

Cost segregation studies can represent an extremely valuable tax strategy for real estate funds and investors. But they’re not always a good fit.

Consider the strategic issues described above to assess whether a cost segregation study makes sense for your real estate portfolio. If you need assistance making this determination or think a cost segregation strategy sounds like a good fit, contact the real estate tax professionals at James Moore.

Our specialized real estate tax team has experience working with real estate developers, funds, and investors across the country. We can connect you with experienced cost segregation study firms and have the expertise required to incorporate the study’s findings into your tax strategy in the most advantageous way possible.

To explore the role a cost segregation study might play in your tax strategy, contact an advisor today.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.