When navigating the complexities of financial management, the cost segregation method can be a helpful tool for optimizing savings within property assets. This method involves identifying and reclassifying certain building components to accelerate depreciation deduction, reduce tax liability and improve cash flow. With the right approach, this method can benefit a range of clients involved in real estate.
1. Commercial property owners.
Owners of commercial properties such as office buildings, retail centers, warehouses and hotels stand to benefit significantly from cost segregation. For example, let’s say a company owns a newly constructed office building.
By conducting a cost segregation study, they may discover that certain components, like the electrical wiring or plumbing, can be classified as shorter-lived assets. This reclassification allows them to accelerate depreciation deductions, resulting in substantial tax savings.
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2. Real estate developers.
Cost segregation can also be a useful planning tool for real estate developers, particularly those involved in new construction or substantial renovation projects. Consider a developer building a mixed-use development with retail space on the ground floor and residential units above.
Through a cost segregation analysis, they may find that items such as specialized lighting fixtures in the retail area or the HVAC systems serving specific sections can be categorized as shorter-lived assets, allowing for accelerated depreciation and reduced tax burdens.
3. Hospitality industry.
Hotels and resorts often have significant amounts of personal property and specialized assets that can benefit from cost segregation.
For instance, a hotel undergoing renovation may find that the decorative lighting fixtures in the lobby or the kitchen equipment in the restaurant can be reclassified for accelerated depreciation.
This can result in substantial tax savings, which can be reinvested into further improving the property or expanding the business.
4. Medical facilities.
Health care facilities, including hospitals, clinics and medical office buildings, can also benefit from cost segregation. Specialized equipment, such as MRI machines, surgical equipment and HVAC systems tailored to maintain specific environmental conditions, may qualify for accelerated depreciation.
By segregating these assets, medical facilities can free up cash flow for necessary investments in patient care and facility upgrades.
5. Manufacturing and industrial facilities.
Manufacturers and industrial facilities often have complex structures and specialized equipment. Cost segregation can help identify components that qualify for accelerated depreciation, such as production machinery, conveyor systems and specialized electrical systems.
By maximizing depreciation deductions, these businesses can improve their bottom line and reinvest in equipment upgrades or expansion projects.
6. Short-term rental owners.
Owners of vacation rentals or Airbnb properties often invest in furnishings, decor and amenities to attract guests and enhance their experience. These assets, including furniture, appliances, electronics and decorative items, can qualify for accelerated depreciation through cost segregation.
By conducting a cost segregation study, short-term rental owners can reclassify these personal property assets separately from the building structure. This allows them to accelerate depreciation deductions on these items over shorter recovery periods, typically five to seven years, instead of the standard 27.5 or 39 years for residential rental property.
Imagine you have a client, Sarah, who owns a beachfront property that she rents to vacationers on Airbnb. The property is fully furnished with high-quality furniture, appliances and amenities to provide guests with a comfortable and luxurious experience. Initially, Sarah depreciates the entire property over 27.5 years, following the standard residential rental property depreciation schedule.
However, after consulting with a tax adviser, she decides to conduct a cost segregation study. The study identifies various assets within the property, such as the furniture, appliances and decorative items, that can be reclassified for accelerated depreciation.
As a result, Sarah can deduct a larger portion of the property’s cost in the earlier years, reducing her tax liability and improving her cash flow, which she can reinvest in property maintenance and guest amenities.
Specialized expertise is required
Cost segregation studies require specialized expertise in both engineering and tax law. Typically, a team of professionals collaborate to conduct a thorough analysis of the property and its components. When performing a cost segregation study, engineering firms, tax preparers and accountants are key players to the process.
Engineering firms. A reputable engineering firm with experience in cost segregation conducts the detailed analysis of the property’s construction and components. They identify which assets can be reclassified for accelerated depreciation based on their useful life and function. Engineers assess various aspects such as the electrical system, plumbing, HVAC, structural components and specialized building features.
Tax advisers or consultants. A tax adviser or consultant, often with expertise in real estate tax law, collaborates with the engineering firm to ensure compliance with tax regulations and optimization of tax benefits. They interpret tax codes and regulations related to depreciation and assist in structuring the cost segregation study to maximize tax savings within legal boundaries.
CPA firms or accounting firms. While CPAs may not conduct the cost segregation study themselves, they play a crucial role in implementing the tax savings identified through the study. They incorporate accelerated depreciation deductions into the client’s tax filings and provide ongoing tax planning and compliance services.
While beneficial to the client, it is important to note that this method can be an expensive option. This is due to the specialized expertise required and the comprehensive nature of the analysis. The cost can vary from $7,500 to $10,000 for residential properties and $10,000 to $15,000 for commercial properties, depending on factors such as the size and complexity of the property, the extent of documentation available and the professionals involved. In many cases, the client bears the cost of the study upfront.
When working with clients, particularly those in the realm of real estate and development, cost segregation can be a beneficial option. While the upfront cost of the study can be significant, the potential tax savings and improved cash flow make it a valuable investment for commercial real estate owners. Clients may choose to engage specialized firms or seek integrated services from advisory practices offering cost segregation alongside other real estate advisory services.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
