What Is Cost Segregation? [And How It Works!] — The Cauble Group (2022)

One of the many reasons commercial real estate is so profitable is the ability to take advantage of depreciation.

As buildings wear out over time, the IRS allows owners of investment properties to deduct a certain amount from their income every year before tax is applied as “depreciation expense”. Since this is an imaginary or paper expense, in that you’re not paying for it out of pocket, the more you claim in depreciation the more you can walk away with after taxes.

Cost segregation is a common way of trying to maximize the amount of depreciation expense you can claim by speeding up the abstract decline in property value. Let’s take a look at how that plays out.

What Is Cost Segregation? [And How It Works!] — The Cauble Group (1)

How Depreciation on a Commercial Property is Calculated

There are a couple different ways you can track depreciation but the simplest is to just find how long it will take the asset to completely fall apart, also known as its “useful life”, and then divide how much you paid for it by that many years.

(Video) What Is Cost Segregation? [Accelerated Depreciation And How It Works]

This method is called “straight line depreciation”, as you end up claiming the same amount every year in depreciation expense. The IRS has set rules for the length of time to use for different items in these calculations, with single and multifamily rentals being expected to last 27.5 years and commercial properties expected to last 39 years.

Don’t be too quick to just take the sale price and divide it by 39 years, though.

Normally when you buy a property, you purchase both the building and the land it sits on, and, while the building can be depreciated, the IRS has stated that land can’t be. So, you’ll have to split that purchase price into two components - one you claim you paid for the land and the other you claim you paid for the building. Once you have a number for the value of the building, you can now divide that by 39 years to come up with your annual depreciation expense.

What Is Cost Segregation? [And How It Works!] — The Cauble Group (2)

How Cost Segregation Works

The term “cost segregation” sounds complex, but the good news is thatit works the exact same way. Since the IRS has different timelines for how long different things will last, it is often beneficial to take the portion of the sale price you paid for the building and split it up even further.

In our price divided by lifetime equation, as the total lifetime an item is expensed over decreases, the annual depreciation expense goes up. So, by redefining which IRS category something falls into, you can potentially claim it has a shorter lifetime and speed up the amount you expense in the early years of ownership. Hence the more common name, “accelerated depreciation.” And remember - since this expense is a paper loss, the higher you can make it, the more income you can keep from being taxed.

Ultimately, how quickly you can benefit from depreciation comes down to how much of your property falls into each of the IRS’s four different categories:

  • Personal property that you have a hand in choosing, like a bathroom fixture or carpeting, can be expensed over 5 or 7 years

  • Improvements to the land, such as sidewalks or fencing, can be expensed over 15 years

  • The building is expensed over 39 years if it is commercial (or 27.5 years if it’s residential)

  • The land is not expensed

The boundaries and definitions on where things fit can be rather vague, making it absolutely critical that you hire experienced professionals to conduct a “cost segregation study” on your property rather than trying to figure it out yourself. Usually the ones conducting the study will have a team made up of accountants, lawyers, and engineers, who work together to decide which things should go into each category.

What Is Cost Segregation? [And How It Works!] — The Cauble Group (3)

(Video) How Cost Segregation Works #Shorts

Example of Cost Segregation

Cost segregation can be a very powerful tool for real estate investors, so let’s look at an example. Rachel invests in an office building that she plans to sell in 5 years, and pays $900,000 altogether to the seller. She talks with her accountant, and they decide that the land value was worth $100,000. Rachel divides the remaining $800,000 over 39 years to come up with a rough depreciation expense of $20,000/year. This means when she sells in 5 years, the total value she will have kept from paying taxes on is around $100,000.

Rachel really wants to increase her depreciation expense so she doesn’t have to pay as much in taxes, so she reaches out to a local firm that she heard does cost segregation studies. After completing their analysis, they tell her that she can claim that a quarter of the $800,000 was used to pay for the interior fixtures and finishes. As “personal property”, this can be depreciated over 5 years instead of 39.

Rachel now does the math to see how much that will change her total depreciation expense over the 5 years before she sells. With this new information, she divides the first $200,000 over 5 years and the other $600,000 over 39 years. She comes up with $40,000/year for the interior fixtures and finishes and roughly $15,000/year for the building, for a total of $55,000/year in depreciation expense the first 5 years the property is owned. She can now shield $275,000 from taxes - a sharp increase!

This example is exaggerated, but it demonstrates the core concepts of cost segregation: split the property value into different IRS categories, assign each the right timeline, and benefit from the accelerated expense schedule.

What Is Cost Segregation? [And How It Works!] — The Cauble Group (4)

Who should Cost Segregate?

Cost segregation studies typically occur as a property is being purchased or directly after, to give the buyer the correct information for their financial records from the start. After this point, the process of keeping things organized is relatively simple as things are worn out and replaced.

In the above example you may have noticed that the only thing that changed was the timing, as either way the full amount of depreciation expense would have been the same at the end of 39 years. However, even if you are holding a property for more than 39 years cost segregation can still provide value by freeing up those tax savings sooner and giving you the opportunity to invest in other projects.

The major limiting factor, however, is pricing. A general recommendation is to look into getting one for property acquisitions that cost more than $750,000, but cost segregation studies do tend to be expensive and are charged on a flat fee basis. As with most things in commercial real estate, it really comes down to each individual property owner’s unique circumstances and financial situation, so it’s best for any commercial real estate investor to consult a CPA or cost segregation specialist for their investment properties.

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FAQs

What do you mean by segregation of cost? ›

Cost segregation is a tax deferral strategy that frontloads depreciation deductions for real estate assets into the early years of ownership. A study segregates the cost components of a building into the proper asset classifications and recovery periods for federal and state income tax purposes.

How does depreciation recapture work? ›

“Depreciation recapture” refers to the Internal Revenue Service's (IRS) policy that an individual cannot claim a depreciation deduction for an asset (thereby reducing their income tax) and then sell it for a profit without “repaying the IRS” through income tax on that profit.

How a cost segregation study works? ›

A Cost Segregation study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27 ½ or 39 years. The primary goal of a Cost Segregation study is to identify all property-related costs that can be depreciated over 5, 7 and 15 years.

What is segregation explain with example? ›

segregation, separation of groups of people with differing characteristics, often taken to connote a condition of inequality. Racial segregation is one of many types of segregation, which can range from deliberate and systematic persecution through more subtle types of discrimination to self-imposed separation.

How do you avoid paying tax on depreciation recapture? ›

Investors may avoid paying tax on depreciation recapture by turning a rental property into a primary residence or conducting a 1031 tax deferred exchange. When an investor passes away and rental property is inherited, the property basis is stepped-up and the heirs pay no tax on depreciation recapture or capital gains.

Do you pay both capital gains and depreciation recapture? ›

A capital gains tax applies to depreciation recapture that involves real estate and properties. The depreciation recapture for equipment and other assets, however, doesn't include capital gains tax.

When you sell a rental property do you have to pay back depreciation? ›

The depreciation deduction lowers your tax liability for each tax year you own the investment property. It's a tax write off. But when you sell the property, you'll owe depreciation recapture tax. You'll owe the lesser of your current tax bracket or 25% plus state income tax on any deprecation you claimed.

Who performs a cost segregation study? ›

Nearly anyone can do a basic cost segregation study which may include some component breakout, but doing it right is the issue. It is fair to say that CPAs, appraisers, contractors, and others can breakdown some of the building components and apply a life to them, especially on new construction.

Why is cost segregation necessary? ›

Higher profitability, lower tax liability, and increased cash flow are the three primary factors which make cost segregation so important. In addition, lower taxes and increased cash flow mean plans for the business can be crystallized and implemented more easily.

Can you do cost segregation on primary residence? ›

Myth 1: “Cost segregation is not available for residential real estate.” That is false. Cost segregation is available for all investment properties, whether they are used for commercial or residential purposes.

What are the 3 types of segregation? ›

Types
  • Legal segregation.
  • Social segregation.
  • Gated communities.
  • Voluntary segregation.

How does the law of segregation work? ›

1: The Law of Segregation states that alleles segregate randomly into gametes: When gametes are formed, each allele of one parent segregates randomly into the gametes, such that half of the parent's gametes carry each allele.

What is segregation method? ›

Share. Information on techniques used to separate dangerous goods, including the use of distance or inert materials, cut-off storage, and detached storage.

What are the three segregation of duties? ›

Segregation of Duties
  • Authorization or approval.
  • Custody of assets.
  • Recording transactions.
  • Reconciliation/Control Activity.

What is segregation of duties in financial accounting? ›

Separation of duties is the means by which no one person has sole control over the lifespan of a transaction. Ideally, no one person should: Initiate the transaction. Approve the transaction. Record the transaction.

Why is segregation of duties important in accounting? ›

Segregation of duties serves two key purposes: It ensures that there is oversight and review to catch errors. It helps to prevent fraud or theft because it requires two people to collude in order to hide a transaction.

What are the different cost segregation techniques? ›

Various methodologies are utilized in preparing cost segregation studies, including: Detailed Engineering Approach from Actual Cost Records. Detailed Engineering Cost Estimate Approach. Survey or Letter Approach.

Who is responsible for segregation of duties? ›

Responsible administrators must consider the principle of segregation of duties when designing and defining job duties. They must implement processes and control procedures that, to the extent feasible, segregate duties among employees and that include effective oversight of activities and transactions.

What are the four major functions of segregation of duties? ›

There are four general categories of duties or responsibilities which are examined when segregation of duties are discussed: authorization, custody, record keeping and reconciliation. In an ideal system, different employees would perform each of these four major functions.

What is segregation function? ›

Separation of duties (SoD), also known as segregation of duties is the concept of having more than one person required to complete a task. It is an administrative control used by organisations to prevent fraud, sabotage, theft, misuse of information, and other security compromises.

What happens when there is no segregation of duties? ›

Inadequate segregations of duties could make fraud prevention, detection and investigation difficult, which could possibly lead to misstated financial statements, regulatory punishments, damage to the company's reputation and reduced investor trust.

What is segregation of duties what function should be performed by different people? ›

The segregation of duties is the assignment of various steps in a process to different people. The intent behind doing so is to eliminate instances in which someone could engage in theft or other fraudulent activities by having an excessive amount of control over a process.

What are the four types of control activities? ›

Key Internal Control Activities
  • Segregation of Duties. Duties are divided among different employees to reduce the risk of error or inappropriate actions. ...
  • Authorization and Approval. ...
  • Reconciliation and Review. ...
  • Physical Security.

Which duties should be segregated? ›

What are some common examples of Segregation of Duties?
  • Persons approving manual journal should not post the same journal.
  • Same person should not do bank reconciliation and vendor payments.
  • Same person should not make payments to vendors and do reconciliation of bank statements.

Why should the person who keeps the records of an asset not be the person responsible for its custody? ›

Answer and Explanation: The person who keeps the records of an asset should not be the person responsible for its custody as it would result to an improper segregation of duties and would create an opportunity for the person to commit fraud.

What are the 5 internal controls? ›

There are five interrelated components of an internal control framework: control environment, risk assessment, control activities, information and communication, and monitoring.

What are the downsides of cost segregation? ›

The process will entail some cost and time. A study could cost as much as $20,000 or more, depending on the location, age of the property, and whether the building is residential or nonresidential. The study could take a month or more to complete.

Do you have to be a real estate professional for cost segregation? ›

In general, depreciation expenses from a building can only be used to offset income generated by that building. Nevertheless, cost segregation can still be appealing for taxpayers who do not qualify as real estate professionals.

Can a CPA do cost segregation? ›

CPAs CAN RECOMMEND USING THE cost segregation technique when a taxpayer constructs a building or buys an existing one. It can be used even if a structure was acquired several years earlier.

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