How Cost Seg Works
A concise, practical explanation of how cost segregation delivers tax benefits and the typical process involved
TLDR: With Cost Segregation, a property owner can get 2% - 10% of their purchase price back as cash in the form of tax reductions in year 1 after purchase (and reduce taxes in future years).
Background On Depreciation
To explain cost seg, we first need to explain the concept of depreciation. Depreciation is the accounting method to reduce the value of an asset over time as it ages. Section 167 of the tax code allows the taxpayer to deduct depreciation for the “exhaustion, wear and tear (including a reasonable allowance for obsolescence)” for property used in its business or for property held for the production of income.
The tax code (and the IRS) allows property owners to use depreciation deductions to offset income, lowering taxable income and the taxes you pay each year.
Typically, taxpayers depreciate their entire property (excluding land, which is not depreciable), over 27.5 years for residential properties (excluding short-term rentals), or 39 years for commercial properties, and using the straight-line method. However, this assumes all components have the same useful life — which is rarely true.
The Role Of Cost Segregation
Bundling all of the components of a property into a 27.5 year or 39 year bucket is overly simplistic and does not reflect reality.
The IRS recognizes that different components of a property have different useful lives. For example, components such as carpet, cabinetry, specialty electrical, and land improvements (sidewalks, fencing) typically require more frequent repair or replacement, and so have shorter useful lives (e.g., 5, 7, or 15 years). Structural components of a building, such as walls and roofs, have longer useful lives (e.g., 27.5 or 39 years).
A cost segregation study is a detailed engineering analysis that identifies and reclassifies components of your property into the appropriate useful life buckets for tax purposes. Our engineering team reviews the details of your property - including the appraisal, property condition report, site survey, construction drawings, construction/renovation costs, etc. - and builds a detailed, engineering-based replacement cost estimate for each component of the property. This allocates a portion of the cost of your property into shorter useful life buckets.
The result of a cost segregation study is accelerated depreciation to the property owner - aka more depreciation in the earlier years. By allocating costs to asset classes with shorter tax depreciation periods, you can claim more depreciation deductions in the initial years of ownership. If you have taxable income to offset, this can result in significant tax savings and increased cash flow. We usually see successful investors use this cash flow to reinvest in more properties, pay down debt, or make other investments.
Bonus Depreciation
Bonus depreciation (technically called the “Special Depreciation Allowance for Qualified Property” by the IRS in the tax code) is a misleading name and can cause confusion. Bonus depreciation does not create more overall depreciation - instead it further accelerates the depreciation that can be deducted in year 1. “Accelerated depreciation” would probably be a more descriptive name. Bonus depreciation only applies to the components and costs in the shorter life tax categories (i.e., the 5 year, 7 year, and 15 year property).
Depending on when your property was acquired, constructed, and placed into service, you may be eligible to claim up to 100% bonus depreciation. This means you could deduct 100% of the costs of the reclassified components in the shorter life tax categories (i.e., the 5 year, 7 year, and 15 year property) in year 1. So, instead of recognizing depreciation deductions equally over 5 years, you will recognize 100% of them in year 1.
Bonus depreciation significantly accelerates your depreciation, increasing the potential tax savings from cost segregation materially.
Cost Seg Example
| Purchase price for a short term rental | $1,000,000 |
| % allocated to land (not depreciable) | 20% |
| Depreciable basis | $800,000 |
| % reclassified into shorter life categories | ~ 25% |
| Assets eligible for bonus depreciation with cost seg | ~ $200,000 |
| Year 1 tax savings with cost seg at a 37% tax rate | ~ $74,000 |
Higher depreciation → lower taxable income → improved cash flow
Note: This example is for informational purposes; actual results will depend on the specific features of your property (e.g., quality of the property, condition, year of purchase, renovation work, location, etc.).
Why Choose MVO
MVO helps real asset owners navigate the complex worlds of tax credits and incentives. Our team has 20+ years of experience performing cost segregation studies.
We are unique in the market by offering a full range of cost segregation services, from DIY studies for single-family residential properties (under our sister brandCost Seg EZ) to fully engineered studies for more complex properties and situations. We focus on delivering the highest quality reports, at a price that ensures a high ROI.
Estimate your tax savings here, or schedule a free consultation here and we can help you.
FAQs
The IRS has an Audit Technique Guide, where it describes the best practices for a cost segregation report that will be accepted by the IRS during an audit. The IRS explicitly states that a cost segregation expert should conduct the study and create the report, and that significant construction and engineering experience is required (See page 35).
Ideally in the same tax year as your acquisition, construction, or renovation — but look-back studies (studies done years later) are very common and can still deliver very attractive tax savings. With a look-back study you do a catch-up without amending prior returns.
Our process to perform a cost segregation study varies based on the situation, but generally follow the following high-level steps:
- Information gathering and initial review: Our information request may include the following items: construction drawings, general contractor’s application for payment, summary of project costs, invoices, purchase and sale agreement, appraisal or inspection, tenant lease agreements, etc.
- Site inspection: Perform an in-person or virtual inspection of the property to determine the nature of the facility, its intended use, and to identify the property's specific assets. During the site inspection, we will gather photographs and take measurements to support our analysis.
- Identify the appropriate asset classifications for the components of the property based on the documentation provided and the information gathered during the site inspection.
- Perform quantity take-offs for certain assets, which includes identifying the types of materials used and then estimating the quantity of each material.
- Identify the direct costs associated with each component of the property previously identified. The source of the direct cost can be a combination of actual project costs and cost estimates.
- Identify any indirect costs associated with the project (e.g., architect’s fees, engineering fees, contractor’s overhead and profit, etc.) and determine how to allocate such costs to the direct costs previously identified.
- Prepare detailed schedules and a report to describe and document the cost segregation analysis.
There are many variations of the above procedures and many sub-steps within each step that we skipped over. But the above is a general explanation of how a cost segregation professional will typically complete a cost segregation study.
There are many different approaches utilized for cost segregation studies. The best practices are suggested by the IRS in their Audit Technique Guide.
The approach used is dependent on a number of factors, including the experience and skill of the person preparing the study, the availability of supporting documentation (e.g., actual construction costs, construction drawings, etc.), whether the property was newly constructed or acquired, and the size and nature of the property. The different approaches range from a detailed engineering approach based on actual cost records to a “rule of thumb” approach (generally not recommended by the IRS except in very certain circumstances). And oftentimes, multiple approaches will be used together as part of the same cost segregation study.
For newly constructed properties & renovations:
- Newly constructed property (including ground up construction, renovations, and additions to existing properties) usually involves construction that was completed by or for the taxpayer and has occurred relatively recently. The property could have been constructed recently or far in the past.
- Detailed documentation is typically available in the form of actual project costs (both direct and indirect) and project construction documents (both drawings and specifications). Additionally, it is sometimes possible for the individual performing the cost segregation study to have access to the parties responsible for the design and construction of the property (e.g., architects, engineers, contractors, etc.).
- In these situations, cost segregation professionals typically use a detailed engineering approach from actual cost records and estimates or surveys where necessary. The cost segregation study relies on actual project documentation when determining the costs of each component of segregated property. This typically means the cost comes from one of the following sources:
- Actual project invoices for direct or indirect costs
- Surveys issued to project participants in order to estimate the cost of certain components that were not segregated in the project invoices
- Cost estimates performed by the cost segregation professional that are based on an engineering analysis of the project drawings and specifications
For acquired properties:
- Acquired property involves existing properties that are purchased by the taxpayer.
- Typically there is little (or no) detailed documentation available related to the construction of the property. In these situations, cost segregation professionals typically use a detailed engineering cost estimate or residual estimation approach. This means that the professional prepares engineering estimates to determine the cost of each component of segregated property.
- These estimates are prepared based on a combination of property drawings (if available) and an inspection of the property. The lack of detailed contemporaneous documentation for acquired properties requires the cost segregation professional to rely more heavily on cost estimating techniques then when performing a study for newly constructed properties.
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