Alternatives to Cost Segregation

[Julio Gonzalez]

I’m sure many of you have heard of a cost segregation study. It is an IRS approved federal income tax tool that increases near term cash flow by utilizing shorter recovery periods for depreciation to accelerate return on investment. For newly constructed, purchased or renovated properties and also retroactive generally over the last 10 years, building components are properly classified into individual units of property and accurate recovery periods for computing depreciation deductions. The study identifies with forensic engineering detail the immediate Bonus Depreciation 5, 7 and 15-year personal property class lives qualifying portions of a building that are normally buried in 27.5 year residential or 39 year commercial categories.

However, there may be alternative tax strategies out there that are more applicable to your current situation or property. It’s always best to ask yourself if this is the best strategy?

Let’s talk through some examples where a cost segregation study may not be the most ideal.

Properties that are near the end of their useful life:

The benefits from a cost segregation study are greater during the early years of owning the property. Near the end of the useful life, there is less value to accelerate, decreasing the benefits of a cost seg.

Properties with small purchase price:

Cost segregation companies should provide you with a quote so that you can determine if the benefits outweigh the cost. Properties with a purchase price under $500,000 may not see as significant benefits, but we have performed studies on properties with a purchase price as low as $150,000, so it’s really a case by case basis.

Properties in which you intend to hold it for a short period of time:

If you plan to hold the properties for less than 5 years, you may want to consider depreciation recapture. While accelerated depreciation provides immediate benefits, part of that is recaptured through taxes when you sell the property.

So what are some alternatives in these cases?

Opportunity Zone Investments

An Opportunity Zone are areas that struggle with poverty and lack the necessary access to economic opportunities. There are over 8,700 zones across the U.S. Investing in these areas comes with multiple tax benefits such as Tax-free growth, Tax payment deferral and Tax discount for long-term commitment.

Strategic Repairs and Maintenance

Strategic planning of repairs and maintenance may not have as significant of an impact as a cost segregation study, it can still be meaningful and even more immediate. Careful timing and classification as either improvements or repairs can increase your deductions.

Bonus Depreciation

Utilizing this strategy, you are allowed to deduct a portion of the cost of certain qualifying assets with useful lives of less than 20 years in the year that you place them into service. As of 2024, the bonus depreciation is 60% (subject to change pending the passing of laws) which allows you to immediately depreciate 60% of the asset’s cost.

1031 Exchange

A 1031 exchange is a tax-savings strategy that allows investors to postpone paying capital gains taxes upon the sale of an investment property by reinvesting the proceeds through the purchase of another property (i.e. a like-kind exchange). Many properties that have undergone a cost segregation study are sold utilizing a 1031 exchange to defer the depreciation recapture. However, a 1031 exchange can be a useful strategy for your property even when a cost segregation study is not a viable option.

Cost segregation can be an incredibly beneficial tax strategy, however it may not be the best strategy for everyone. Ensure you are engaging your CPA or tax strategist experts to help with tax planning for your portfolio and understand that this is a different service than your standard tax preparation.

What tax strategies have you utilized in your real estate portfolio?