Cost segregation studies are a powerful tax planning tool for commercial property and residential rental owners, offering significant savings by accelerating depreciation deductions.
By reclassifying a portion of building components into shorter depreciation periods, owners can frontload deductions, reduce tax liability, and improve cash flow.
This article provides a comprehensive overview of cost segregation studies, their benefits, practical applications, and key considerations for implementation in 2025, including the impact of bonus depreciation and complementary tax incentives.
Understanding Cost Segregation
A cost segregation study involves a detailed, engineering-based analysis of a commercial property to identify components that can be depreciated over shorter periods—typically 5, 7, or 15 years—rather than the standard 39-year schedule for commercial properties or 27.5 years for residential rental properties. Components such as interior fixtures, finishes, kitchens, security systems, accent lighting, wood flooring, and land improvements (e.g., parking lots, landscaping) qualify for accelerated depreciation under IRS guidelines.
These studies are conducted by qualified engineers who ensure compliance with the Internal Revenue Service (IRS) Cost Segregation Audit Techniques Guide. The process requires reviewing property records, blueprints, appraisals, and inspection reports to allocate costs accurately to different asset categories.
Key Benefits of Cost Segregation Studies
1. Significant Tax Savings
Cost segregation studies can reclassify 15%-40% of a property’s depreciable basis into shorter-lived assets, leading to larger deductions in the early years of ownership. This acceleration reduces taxable income and, consequently, tax liability.
- Accelerated Depreciation: For a $1,000,000 commercial property with a $200,000 land value, the depreciable basis is $800,000. Standard depreciation yields an annual deduction of $20,512.82 ($800,000 ÷ 39). A cost segregation study might reclassify $300,000 into shorter periods (e.g., $100,000 each to 5-, 7-, and 15-year property), resulting in a first-year deduction of $53,772.89. At a 37% tax rate, this results in an additional savings of $12,306.63 compared to standard depreciation.
- Bonus Depreciation: In 2025, owners can claim 40% bonus depreciation on qualified property placed in service after December 31, 2024, and before January 1, 2026. This applies to assets with a recovery period of 20 years or less, such as personal property or qualified improvement property (QIP). For example, if $300,000 of reclassified assets qualifies, an immediate deduction of $120,000 (40% of $300,000) can be taken, yielding tax savings of $44,400 at a 37% tax rate
2. Increased Cash Flow
The tax savings from accelerated depreciation and bonus depreciation provide immediate cash flow benefits. For instance, the additional $12,306.63 in tax savings from cost segregation can be reinvested into property upgrades, debt repayment, or other business ventures. When combined with bonus depreciation, savings can exceed $56,000 in the first year for a $1,000,000 property, significantly enhancing financial flexibility.
3. Complementary Tax Incentives
Cost segregation studies often reveal eligibility for additional tax benefits, enhancing overall savings:
- Section 179D Deduction: Offers up to $5 per square foot for energy-efficient upgrades in commercial buildings, such as efficient lighting or HVAC systems
- Section 45L Credits: Available for energy-efficient residential properties, providing credits for qualifying improvements.
- Sales and Use Tax Savings: Studies may identify components exempt from certain state taxes
- Partial Asset Dispositions: If an extensive renovation or improvement is planned, a cost segregation study will enable the expensing of all disposed-of building components.
4. Look-Back Study Option
Owners of properties held for several years can conduct “look-back” studies to claim missed depreciation deductions from prior years without amending tax returns. This is facilitated through IRS Form 3115, which allows a change in accounting method to reclassify assets retroactively. This option makes cost segregation valuable even for long-held properties.
5. Time Value of Money
By frontloading deductions, cost segregation studies capitalize on the time value of money. Tax savings realized earlier can be reinvested or used immediately, compounding financial benefits over time. This is particularly advantageous in high-interest-rate environments, where early cash flow is critical.
When to Conduct a Cost Segregation Study
- Optimal Timing: The ideal time is in the year of acquisition, construction, or major renovation, as this maximizes early deductions and eliminates the need for IRS forms. Properties valued over $1,000,000 or with renovations exceeding $300,000 typically yield the highest returns.
- Look-Back Studies: Studies can be conducted at any time, even for properties owned for decades. Look-back studies recover missed deductions, making them a valuable option for owners who missed earlier opportunities.
- Property Types: Multifamily properties and office buildings often have more short-life assets (e.g., interior finishes) than industrial buildings, leading to greater reclassification potential.
Practical Example
Consider a $1,000,000 commercial retail center purchased in 2025, with $200,000 allocated to land, leaving a $800,000 depreciable basis. Without cost segregation, the annual depreciation deduction is $20,512.82. A cost segregation study reclassifies $300,000 as follows:
- Without Cost Segregation:
- First-year depreciation: $20,512.82
- Tax savings at 37%: $7,589.74
- With Cost Segregation:
- First-year depreciation: $53,772.89
- Tax savings at 37%: $19,896.37 (additional $12,306.63)
- With 40% Bonus Depreciation (2025):
- Immediate deduction on $300,000 reclassified assets: $120,000 (40% of $300,000)
- Remaining depreciation: $33,772.89
- Total first-year deduction: $153,772.89
- Tax savings at 37%: $56,896.37
This example illustrates how cost segregation can nearly triple first-year deductions, with bonus depreciation further amplifying these savings.
Key Considerations
- Depreciation Recapture: Accelerated deductions increase depreciation recapture upon sale, taxed at ordinary income rates (up to 37%). A 1031 exchange can defer this tax by reinvesting proceeds into like-kind property.
- Professional Guidance: Studies typically cost $5,000-$15,000 but often yield savings far exceeding this expense. Engaging qualified professionals ensures accuracy and IRS compliance.
- State Tax Variations: Some states, such as California, do not conform to federal bonus depreciation rules, which can potentially reduce state-level savings.
- Audit Risk: Aggressive reclassifications may trigger IRS scrutiny. Studies must adhere to IRS guidelines to minimize the risk of audit.
- Legislative Uncertainty: Bonus depreciation is set to phase out (20% in 2026, 0% in 2027), but Congress may extend it, as attempted in 2024
Practical Tips for Implementation
- Hire Qualified Professionals: Engage engineers and CPAs with cost segregation expertise to ensure compliance and maximize savings.
- Act Promptly: Conduct studies in 2025 to leverage 40% bonus depreciation before it drops to 20% in 2026.
- Maintain Documentation: Provide blueprints, appraisals, and inspection reports to support the study’s findings during IRS audits.
- Explore Look-Back Studies: For older properties, consider retroactive studies to claim missed deductions.
- Monitor Tax Law Changes: Stay informed about potential extensions of bonus depreciation or other tax provisions.
Conclusion
Cost segregation studies are a game-changer for commercial real estate owners seeking to maximize tax savings and improve cash flow. By accelerating depreciation deductions and leveraging 40% bonus depreciation in 2025, owners can significantly reduce their tax liability, particularly for newly acquired or renovated properties. Additional incentives, such as Partial asset Dispositions and the flexibility of look-back studies, further enhance their value. However, the complexity of tax rules and risks, such as depreciation recapture, necessitate professional guidance. Acting promptly and strategically can help owners capitalize on these opportunities before bonus depreciation phases out further.