One of my mentors told me “It’s not how much you make, it’s how much you keep”. That resonated with me in a big way and ever since I’ve been just as proactive, if not more, about my strategic tax planning as I am about my business and investments. Most people know that owning real estate is a powerful wealth building strategy that comes with a variety of other benefits, favorable tax treatment being one of them. But for most, that’s where their knowledge ends. This is very unfortunate because if they just dug a little deeper, they would likely come across a power tax strategy known as Cost Segregation.

A cost segregation analysis is a tax planning tool used in commercial real estate investing that takes advantage of the depreciation rules. Buildings are typically depreciated over a long period—27.5 years for residential properties and 39 years for non-residential properties. It involves identifying and reclassifying certain components of a property and taking the depreciation deductions over a shorter period of time. The main objective of this analysis is to reduce your current income tax liabilities which in turn increases cash flow and improves ROI.

You might be wondering which components are eligible for this treatment. The most common are electrical systems, plumbing, lighting fixtures, and specialized equipment. All of these have depreciable lives less than 39 years. In my article, Go Green, Grow Your NOI, I highlighted a number of energy efficient applications available to property owners. Spoiler Alert…All of these applications are eligible! Think about it…you can increase your NOI by reducing operating expenses, check the “sustainability” box and get a massive tax savings all at once! Talk about a win-win-win!

What if you bought a property a few years ago and are just now learning about this strategy? Well, you are in luck. While the best time to perform a cost seg study is within the tax year that you purchased it (or completed construction), you are able to do a “look-back” study done on assets acquired as far back as 1987. You claim the resulting write-off’s using a rule known as “3115 Automatic Change” without having to amend any prior year tax returns. That said, there are diminishing returns to performing a study the longer you own and depreciate a property so be certain to consult your tax advisor before making any moves. Lastly, if you are planning on renovating your property, its best to perform a cost seg study prior to those renovations.

Let’s consider an example to illustrate the benefits of a cost segregation analysis:

Suppose you purchases a commercial property for $1 million and, without cost segregation, would have to depreciate the entire amount over 39 years. Using a cost segregation analysis, the investor determines that $200,000 can be allocated to components with a shorter depreciable life of 5 years, such as carpeting, lighting, and certain equipment.

By reclassifying this portion to 5-year property, the investor can now depreciate $200,000 over 5 years instead of 39 years. Assuming a tax rate of 30%, this reclassification would result in an immediate tax savings of $60,000 ($200,000 * 30%). This increased cash flow can be reinvested or used for other purposes, enhancing the investor’s overall return on investment.

Furthermore, the benefits of cost segregation extend beyond the immediate tax savings. In some cases, investors may be able to take advantage of bonus depreciation provisions, such as those provided by the Tax Cuts and Jobs Act (TCJA), which allow for an even greater upfront deduction.

This sounds too good to be true, right? While cost segregation can be advantageous in many situations, there are a few scenarios where it may not provide significant benefits or may even be less beneficial for a property owner. Here are a few instances where cost segregation may not be as advantageous:

Short ownership period: If you plan to hold the property for a relatively short period, such as a few years, the tax benefits gained from cost segregation may not outweigh the costs of conducting the analysis. If you are planning to sell the property in a taxable transaction (i.e. Not doing a 1031 exchange) a cost seg study may not make sense because of recapture tax.

Low tax liability: If a property owner has a low taxable income or tax liability in the first place, the immediate tax savings from cost segregation may be minimal. Since the primary advantage of cost segregation is reducing current income tax liabilities, it may not provide significant benefits if the owner’s tax burden is already low.

Passive income limitations: The benefits of cost segregation are most advantageous for property owners who have active participation in real estate activities and can use the accelerated depreciation deductions to offset other active income. However, if the property owner has passive income limitations or is subject to passive active loss rules, the benefits of cost segregation may be restricted.

As you can see, a cost segregation study has the potential to be a game changer. However, it’s essential to consider all of these factors and consult your tax professional and other advisors who can evaluate the specific circumstances of the property and your specific tax situation to determine if a cost segregation would be beneficial. Once your tax professional gives you the green light, the analysis should be conducted by a qualified professional such as an engineer or tax expert. This ensures compliance with applicable tax laws and regulations while maximizing the tax benefits for the investor.

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