A Guide to Cost Segregation in Commercial Real Estate

In the current market, commercial real estate margins are getting tighter and tighter. Rising construction, borrowing, and operational costs alongside broader economic headwinds have left little on the table for investors to take home at the end of the day. However, investors may be overlooking one easy strategy to maximize returns: cost segregation. Cost segregation is a tax deferral strategy that reduces the property depreciation timeline. Investors utilizing cost segregation will reduce their tax liability as well as increase cash flow. The benefits can have a big impact on the project’s bottom line. 

Here is a guide to cost segregation, and how you can use it on your project to improve profitability. 

What Is Cost Segregation in Commercial Real Estate? 

Cost segregation is a tax deferral method that allows an owner to segregate aspects of an asset that can be depreciated over a shorter period than the standard 39-year timeframe. In the standard tax depreciation method, the building depreciates evenly over 39 years, but using cost segregation, an owner can identify features or components of the building that depreciate faster. The shortest appreciation offered through a cost segregation study is 5 years. The building’s plumbing, HVAC, and electrical are examples of systems that have shorter depreciable lives, as allowed by the IRS. 

By segregating each of these components, owners are able to reduce their overall tax liability—and the savings can be substantial. Depending on the building and the cost segregation strategy used, you could potentially write off 30% to 35% of the property’s purchase price value in the first year, according to Engineered Tax Services. Eisner Amper says that cost segregation has an actual return of “well over” 10-to-1. Or, in an example used on Plante Moran, if a $3 million property has 20% of its assets qualify for a bonus depreciation, at a 35% tax rate, the owner would see an ultimate cost savings of $200,000 in the first year. This significant savings gives owners a lot of options. Not only does it expand the profitability margin, but owners could take the savings and invest it in other investments or use the savings to make large property repairs. Some of those repairs, like a roof or window replacement, could also qualify for a cost segregation study after the first year, creating additional savings opportunities. 

How to Implement a Cost Segregation Strategies

While residential assets are the most common, any real estate asset can utilize cost segregation. Owners should start by enlisting a team of professionals. As Eisner Amper explains, in the IRS guide to Cost Segregation and Audit Techniques, the first recommendation is preparation by an individual with experience and expertise. A construction engineer is essential to inspect the property to identify the parts of the building eligible for a shorter depreciable life. The engineer will identify the right components, assign a cost, and categorize them by lifespan. Not only is this step necessary, it is in the owner’s best interest to have a professional analysis to maximize the savings. 

Next, a tax professional should analyze the engineer’s report to properly make the deduction. The process to properly file the dedication and reap the benefit is complicated, and owners need to comply with the IRS rules and regulations, including the proper classification. As the IRS says, “to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset.”

Finally, cost segregation is best used directly following the purchase of an asset or completion of a new construction project. After the purchase or completion of an asset, the construction engineer will have the best opportunity to review property components when they are first placed into service by ownership. This will maximize the potential value from the cost segregation study. However, cost segregation studies can be used at other times during the life of the property. The IRS does offer a “look back” opportunity to take advantage of past depreciation opportunities. 

It is worth noting that a cost segregation strategy costs $10,000 to $25,000, depending on the size of the property. This is not an inexpensive endeavor, but the cost savings will offset the price. 

Technology Can Boost Your Cost Segregation Strategy

The ultimate goal of cost segregation is to reduce tax liability and increase the investment returns—or help meet them in a market where finding a return can be challenging. To amplify that savings, cost segregation should be part of a larger efficiency strategy. Technology is another opportunity to create cost-saving efficiencies, and the right software programs can help boost a cost segregation strategy. Modern real estate development software like Northspyre create valuable efficiencies that can drive returns. Northspyre generates financial forecasts, tracks budgets and spending and automates invoicing. In a cost segregation strategy, the quality record keeping can help tax advisors find and pinpoint depreciation opportunities, but it also produces a consistent ROI, cut costs and deliver accurate project forecasts that also help expand return margins. Like cost segregation, technologies like Northspyre should be part of the toolbox to maximize property value.

There is no doubt that commercial real estate investment and development are challenging in the current market—but innovative and creative investors can utilize alternative tools and strategies to find value in every deal. 

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