The famous author Mark Twain once stated "…that the difference between a tax collector and a taxidermist is that a taxidermist only takes your skin." Whether utilizing IRC §1031 tax deferred exchanges or maximizing tax write-offs, savvy real estate investors eagerly look for ways to minimize their tax liability. A recent and little-known change in the tax laws created a new opportunity for real estate investors to receive tremendous tax advantages.

A cost segregation study is a powerful strategy that allows investors who have constructed, purchased, remodeled or expanded virtually any type of commercial real property to improve their rate of return by deferring income taxes to a later tax period. By accelerating depreciation deductions and deferring federal and state income taxes, the property owner is able to increase the profitability of their investments.

What is a Cost Segregation Study?

A cost segregation study is an accounting and engineering-based analysis and reclassification of the real and personal property contained in an investment property. Real property is assigned a 27.5-year or 39-year straight depreciation deduction under the Modified Accelerated Cost Recovery System (MACRS). However, land improvements and personal property can have significantly more advantageous depreciation ("cost recovery") periods. Tax savings are generated by properly reclassifying shorter asset lives (5, 7, and 15-year depreciation schedules) for assets that were otherwise lumped in with the property's acquisition or construction costs. Without a cost segregation study, the cost basis of the shorter-life assets are typically undifferentiated from the construction costs or purchase price and are reflected at the longer 27.5 and 39-year depreciation periods.

What is the Perspective of the IRS?

In 1997, a significant Tax Court case, Hospital Corp. of American, Inc. (HCA), resulted in property owners being able to obtain much more favorable treatment on their allowable depreciation. In the HCA ruling, the Tax Court allowed the property owner to take advantage of the depreciation deduction advantages between Investment Tax Credit property (sometimes referred to as "Section 38 property") and non-Investment Tax Credit property that were previously available in 1962. Investment property owners could obtain greater depreciation benefits on the non-structural components (now known as 1245 property) versus the definition of the building and its structural components (now referred to as Section 1250 property.), Consequently, real estate investors who precisely segregate the real and personal property aspects obtain better tax advantages immediately.

The IRS made another change that was beneficial to property owners. Before 1997, depreciation that had been understated due to a prior years' miscalculations was only recoverable by amending tax returns if the mistake occurred in the last three years. In 1997, the IRS made a change that allows property owners to recapture previously missed depreciation deductions they were entitled to after 1986. The total amount of the missed depreciation from all prior years can now be taken during the current tax year. This is significant because it enables property owners to deduct all previously missed depreciation deductions together on the current tax return!

Benefits of a Cost Segregation Study

Although every project is different, real estate investors typically see an immediate savings of 15% - 45% by reclassifying assets from real property depreciated over 27.5 or 39 years to personal property depreciated over 5 or 7 years or land improvements over 15 years. Examples of typical savings are as follows:

Project Type Percentage Savings

Apartments 25% - 30%
Automobile Dealers 30% - 35%
Banks 40% - 45%
Hotels 25% - 30%
Grocery Stores 35% - 40%
Offices 15% - 20%
Manufacturing Buildings 35% - 50%
Medical Facilities 30% - 35%
Restaurants 35% - 40%
Retail Buildings 25% - 35%
Warehouses 15% - 20%

When is a Cost Segregation Study Beneficial?

The majority of real estate investors who own commercial buildings can benefit from a thorough cost segregation study if desiring the following benefits:

1. A better rate of return in the first year of ownership;
2. Improving immediate cash flow;
3. Accelerating depreciation deduction through the reclassifying of my assets into optimum property classifications;
4. Obtaining increased depreciation benefits in the current year, for past tax years - without having to file an amended tax return.

The Bottom Line

Many investors are not taking advantage of legally allowable depreciation deductions and are overpaying income taxes. A comprehensive cost segregation study has the potential to significantly reduce an investor's tax liability. If the assets are optimally categorized and depreciated, the study will immediately improve the property owner's bottom-line tax savings and cash flow.