Cost segregation is a tax deferral strategy that allows depreciation deductions for real estate assets to be “frontloaded”, or taken in the earliest years of that property’s ownership. A cost segregation study accomplishes this by analyzing the improvements at a given commercial real estate property and classifying the various components into their appropriate depreciation classes, in accordance with IRS guidelines.

Accelerated depreciation is essentially any depreciation method that allows for the recognition of higher depreciation expenses during the earlier years of an asset’s holding period. It differs from straight-line depreciation, which spreads depreciation expenses evenly throughout the life of the asset.

In consideration of accelerated depreciation for real estate improvements, a Cost Segregation study will identify the various building and site improvement components of a real estate asset and classify them into their appropriate depreciable life classes (typically 5-year, 7-year, 15-year, and 27.5- or 39-year asset classes), per IRS guidelines. Check out the Case Studies page for some specific examples of accelerated depreciation via a Cost Segregation study versus straight-line depreciation.

Taking the maximum allowable depreciation in the early years of real estate ownership reduces the tax liability (or put another way, increases the tax savings) in those years. In turn, this tax savings results in an increase in cash flow, which can then be invested in other aspects of the business, or distributed as appropriate.

The short answer is, absolutely not. To the contrary, the IRS fully supports, if not encourages, quality cost segregation studies that are performed in compliance with their published guidelines.

The key caveat here though is “quality.” The IRS actually specifies that a quality Cost Segregation study will include 13 principal elements (see below).

In performing literally thousands of studies, we have had three instances which required dialogue with the IRS to resolve questions about a report. None of these questions had to do with the quality of the report itself, but rather clarification on the use of a specific asset. In all of these instances the question was resolved efficiently via a conference call, and without additional issues.

This said, while an IRS audit is rare, the best defense against against an audit is to have a rock-solid, IRS-compliant study that meets all IRS guidelines. JC Hannah meets or exceeds all of these essential elements in their studies:

1. Preparation By An Individual With Expertise and Experience

2. Detailed Description Of The Methodology

3. Use of Appropriate Documentation

4. Interviews Conducted With Appropriate Parties

5. Use Of A Common Nomenclature

6. Use Of A Standard Numbering System

7. Explanation Of The Legal Analysis

8. Determination Of Unit Costs And Engineering “Take-Offs”

9. Organization Of Assets Into Lists Or Groups

10. Reconciliation Of Total Allocated Costs To Total Actual Costs

11. Explanation Of The Treatment Of Indirect Costs

12. Identification And Listing Of § 1245 Property

13. Consideration Of Related Aspects (e.g. I.R.C. § 263A, Change in Accounting Method And Sampling Techniques)

Any property that is used for commercial purposes is a candidate for a Cost Segregation study. Put another way, any property other than an individual’s primary dwelling/residence would qualify. With this in mind, not only does this include the traditional commercial occupancies such as office buildings, retail centers, and apartment buildings but also single-family rental homes, Airbnb units, leased condominiums or townhomes, and everything in between. Please see the Case Studies section for a non-exhaustive list of commercial properties that are candidates for a Cost Segregation study.

The depreciation of any asset requires a date from which the depreciation should begin. In the accounting world this is referred to as the “in-service date.” Typically, the in-service date for a real estate asset is the date the property was purchased, or in the case of newly-constructed property the date the project was completed. Additional in-service dates would be used for any new improvements completed after the initial purchase date, such as the renovation of a tenant space or the addition of other, new capital improvements.

With this in mind, the ideal time to perform a Cost Segregation study is as soon after the in-service date as possible, as this will provide the best snapshot of the property’s assets and condition as of the date depreciation will begin (and before any post-acquisition improvements are completed).

However, it is not only acceptable but fairly commonplace to perform a study on a property that was purchased, constructed, or improved upon in prior years. Often termed as “look back” studies in the industry, current IRS guidelines allow property owners to “catch up” on any depreciation that they could have taken in prior years, but did not.

It is perfectly acceptable, and even somewhat commonplace, to perform a study on a property that was purchased, constructed, or improved upon in prior years. Often termed as “look back” studies in the industry, current IRS guidelines allow property owners to “catch up” on any depreciation that they could have taken in prior years, but did not. Very frequently, a look back study such as this can provide significant tax savings for the current tax year.

Newly-constructed properties are outstanding candidates for a Cost Segregation study, both from the standpoint of being able to immediately benefit from depreciation of the new asset, as well as the fact that typically the study can be completed using actual line item cost data rather than estimated cost data. Estimated cost data from a reputable, industry-recognized cost source is completely acceptable by the IRS, but particularly in the case of newly-constructed properties, actual cost data is always preferred.

It is common for improvements of varying scales to be performed on a property after purchase. For example, a self-storage facility may require a new security system and fencing; an apartment complex may require new flooring and appliances as units turn over; or a retail center may provide a new tenant with a tenant improvement allowance which is used for new, custom flooring, millwork, and lighting packages.

In all such situations the improvements made after the initial purchase, or capital expenditures, should also be segregated into their appropriate asset classes and depreciated according to IRS guidelines.

A Cost Segregation study from JC Hannah will consider not only the property that was in place as of the purchase date, but also any improvements that were made to the property after the initial purchase.

While every property and study is unique, below are the typical steps involved in completing a cost segregation study:

1. Initial Engagement

○ We first obtain some basic information regarding your property portfolio, such as the purchase date, purchase price, address, and property type/use.

○ We then perform a preliminary analysis to determine the estimated tax benefit that would be realized by completing a cost segregation study. This analysis is provided free of charge.

○ We provide this benefit analysis to you, including our proposed fee and due date for completing the study. Often our client will introduce us to their tax professional directly in order to go over the analysis and answer any additional questions.

2. Formal Engagement

○ Once we agree to move forward with the study, we will begin making arrangements to visit the property. If there is a site contact at the property we will contact them directly to make arrangements for the site visit.

○ We will also ask for any additional documentation you may have related to the property, such as a prior depreciation schedule, survey, or property condition report, if available. then perform a preliminary analysis to determine the estimated tax benefit that would be realized by completing a cost segregation study. This analysis is provided free of charge.

3. Property Visit

○ A thorough property inspection by a qualified and experienced cost segregation profession is critical for maximizing the tax benefit that can be realized from the study. We will walk through all accessible interior spaces, as well as the property exterior, in order to identify the various building components and site improvements that qualify for accelerated depreciation.

○ The length of the site visit depends on the property's complexity. For example, a drive-up storage unit will take less time than a 10-story office building with 40 tenants, or a 20-acre apartment complex with six different floorplans. We are respectful of the staff's time while on-site, as well as that of any tenants, and we do everything we can to prepare beforehand so that our visit is both thorough and efficient.

4. Finalize & Deliver Report

○ We will assimilate all of the information gained from the site visit into a final report. The report will itemize the building and site components into their appropriate 5-year, 7-year, 15-year, and 27.5/39-year depreciation classes, along with their respective cost.

○ The report will also include photos taken from the site visit, a description of the property and our findings, and any relevant supporting documentation. Again, our final report deliverable exceeds the IRS quality report standards.

○ After delivery we will go over the report with you and/or your tax professional to answer any questions. If any amendments are necessary we will revise accordingly.

5. Continued, Long-term Support

○ In the unlikely event of questions from the IRS, or even an audit, we will defend our study at absolutely no charge to you, up to and including expert witness testimony in court. Again, the best defense is always going to be a rock-solid, IRS-compliant report, which is why we are confident in offering this long term support to our clients.

In the unlikely event of questions from the IRS, or even an audit, we will defend our study at absolutely no charge to you, up to and including expert witness testimony in court. Again, the best defense is always going to be a rock-solid, IRS-compliant report, which is why we are confident in offering this long term support to our clients.

Depreciation recapture is an important concept for a real estate investor to be aware of, because it allows the IRS to tax a portion of the gain on the sale of property at ordinary income tax rates, as opposed to the more favorable capital gains rate. Given the changing nature of tax laws it is difficult to precisely calculate the tax impact of selling a property at some undetermined date in the future. The important things to understand here are, first, that depreciation recapture is something that will need to be accounted for at the time of the property’s disposition and, second, that in the vast majority of cases a cost segregation study is still going to make sense and will provide the most impactful benefit on cash flows today.

Below are a few key questions you should ask a provider before engaging them to perform a cost segregation study:

1. What is their experience level? This one is obvious, but how long have they been practicing cost segregation and how well can they explain the expected benefits that you will receive from completing a study.

2. What is their final deliverable? “The devil is in the details,” and this is particularly true when it comes to the quality of a particular study. To what level do they break out building components (many providers will focus on the short-life, Section 1245 components but do the bare minimum required by the IRS when it comes to the structural, Section 1250 building components. This becomes particularly important down the line when, for example, there is tenant turnover or other improvements/renovations where certain building components are disposed of. A quality study will be something that you or your tax professional can reference to assist in the decision-making for these important tax-related issues.

3. Who will be visiting the property? Every property is unique, and the person visiting your property should be knowledgeable in building construction and systems, and experienced in identifying which components qualify for accelerated depreciation. Know who is visiting your property and their level of experience, otherwise there’s a good chance you’ll be leaving money on the table.

4. Make sure they understand the provision of “recapture” and can explain to you the potential tax impact should you decide to dispose of the property in the future.