Accelerated Depreciation and Cost Segregation Studies | Tax (2023)

Depreciation is an annual income tax deduction in which the IRS allows a taxpayer to write off a portion of the property’s cost each year and can be a powerful tax savings tool. Depreciation is based on the purchase price, or cost basis, of the property. The cost basis is then divided by the useful life of the property to determine the deduction allowed each year. For buildings, the lives are 27.5 years for residential real estate and 39 years for commercial real estate. Because of the long depreciable life of a building, accelerated depreciation strategies should be considered.

It is important to note that accelerating depreciation does not mean you receive extra depreciation; it simply means that you are speeding up the benefits to today rather than waiting to receive them. One way to do this is through a cost segregation study.

What is a Cost Segregation Study?

A cost segregation study is a tax strategy designed to accelerate depreciation expense. Cost segregation studies can fit into a few different categories. We will focus on acquired property, new construction and building renovations. These cost segregation studies combine accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property. This could potentially allow you to accelerate depreciation deductions, thus reducing taxes and boosting cash flow.

This is achieved by reclassifying some of the components of a building from an asset with a long depreciable life into assets with shorter depreciable lives. Examples include flooring, appliances, specialty plumbing & electrical, cabinets, roofing, HVAC units, and land improvements such as parking lots. Once these components are broken out, an accelerated tax deduction is achieved because those components can be written off over a shorter time period.

Because of the detailed reporting that the IRS requires in order to take the accelerated depreciation adjustment, it is recommended the cost segregation study be completed by a firm that specializes in the field. As with all business decisions, there is a cost/benefit analysis that should be considered to determine whether the tax savings resulting from the cost segregation study outweigh the costs to get the study done. For example, if your business is projecting a loss in one year but anticipates revenue in future years, it may be advantageous to wait until the business is generating income.

(Video) Cost Segregation Study - Bonus Accelerated Depreciation (BIG Tax Cuts Job Act CHANGES)

A cost segregation study can be completed at any time on property you own. It does not need to be done in the year you first purchase the property or place it in service. Also, unlike most tax strategies, the cost segregation study does not need to be implemented before the end of the tax year, although it does need to be completed before the tax return is filed. This allows the taxpayer to determine whether the cost segregation study might benefit them depending on their tax liability for the year.

Depreciation Recapture

It is reasonable to be concerned that taking more depreciation now will lead to higher taxes later when the property is sold. Although it is true that a cost segregation decreases the investor’s tax basis, which thereby increases the future capital gains on the property, it can still be beneficial to have a cost segregation done. Many taxpayers prefer deferring taxes into the future in order to have cash available that they can put into their business today.

IRS rules generally allow businesses to depreciate commercial buildings over 39 years (27½ years for residential properties). In most cases, a business will depreciate a building’s structural components such as walls, windows, HVAC systems, elevators, plumbing and wiring as well as the building.

Personal business property such as equipment, machinery, furniture and fixtures is also eligible for accelerated depreciation, but usually over five or seven years. Land improvements including fences, outdoor lighting and parking lots are depreciable over 15 years.

It is common for businesses to allocate all or most of a building’s acquisition or construction costs to real property and overlook the opportunities to allocate costs to shorter-lived personal property or land improvements. For instance, computers and furniture have obvious distinctions between real and personal property, but often the line between the two is less clear. Items that appear to be part of a building may be personal property, like a removable wall and floor coverings, removable partitions, awnings and canopies, window treatments, signs and decorative lighting.

In some cases where real property serves more of a business function than a structural purpose, it may qualify as personal property. This includes reinforced flooring to support heavy manufacturing equipment, electrical or plumbing installations required to operate specialized equipment or dedicated cooling systems for data processing rooms.

Although the relative costs and benefits of a cost segregation study depend on your facts and circumstances, it can be a valuable investment. Let’s say the business acquired a nonresidential commercial building for $5 million on January 1. If the entire purchase price is allocated to 39-year real property, the business is entitled to claim $123,050 (2.461% of $5 million) in depreciation deductions the first year. A cost segregation study may reveal that you can allocate $1 million in costs to five-year property eligible for accelerated depreciation. Reallocating the purchase price increases your first-year depreciation deductions to $298,440 ($4 million × 2.461%, plus $1 million × 20%).

(Video) What Is Cost Segregation? [Accelerated Depreciation And How It Works]

A cost segregation study can assist you in making partial asset disposition elections and deducting removal costs under the recently issued final tangible property regulations.

Section 179 and Bonus Depreciation

There are more ways than a cost segregation study to accelerate depreciation, such as the Section 179 deduction. The Tax Cost and Jobs Act (TCJA) enhanced certain depreciation-related tax breaks which may also enhance the benefits of a cost segregation study. Among other things, the TCJA permanently increased limits onSection 179 expensing. Section 179 allows you to immediately deduct the entire cost of qualifying equipment or other fixed assets up to specified thresholds.

Under Section 179 expensing, taxpayers can take a current deduction for the cost of qualified new or used business property placed in service in the tax year, up to certain limits.This applies to tangible personal property, such as machinery or equipment, purchased for use in a trade or business, and improvements to the interior portion of a nonresidential building after the building is placed in service. Additional items include roofs, HVAC, fire protection systems, and alarm or security systems for nonresidential real property. Taxpayers can deduct the full cost of these assets up to $1,050,000 for qualifying property placed in service in 2021. However, the section 179 deduction begins to phase out on a dollar-for-dollar basis after $2,620,000 of spending.

Another method to accelerate is through bonus depreciation. Currently, this allows a business to write off 100 percent of the purchase price of qualified depreciable property in the year of acquisition. Qualified depreciation property includes property with a recovery period of 20 years or less (meaning taxpayers cannot take bonus depreciation on buildings), qualified improvement property, computer software, and certain used property The bonus depreciation deduction is available for property acquired and placed in service after September 27, 2017 and before January 1, 2023.

The Section 179 deduction can be used alongside bonus depreciation to maximize the effectiveness of a cost segregation study. However, there are a few things to consider when determining which strategy will be most effective.

The Section 179 deduction is flexible and allows you to choose which purchases to elect it for, but there is a spending cap and the deduction cannot be larger than your annual business income. Bonus depreciation has no annual spending limit and can exceed your business income, but you must apply the same treatment to all assets of the same class.

Qualified Improvement Property

“Qualified improvement property” (QIP) is any improvement made to an interior portion of nonresidential real property if such improvement occurred after the building was first placed in service. The TCJA expanded 15-year-property treatment to apply to QIP. Previously, this tax break was limited to qualified leasehold-improvement, retail-improvement, and restaurant property.

QIP does not include expenditures attributable to enlargement of the building, any elevator or escalator, or the internal structural framework of the building. When a cost segregation study is completed, it is likely that a large portion of the reclassified components might be considered QIP. In prior tax law, this was not eligible for bonus because its useful life exceeded the 20 year threshold.

As of April 2020, the IRS now states that QIP placed in service subsequent to December 31, 2017 has a recovery period of 15 years. This change allows for QIP to be eligible for 100 percent bonus depreciation through the year 2026. The provision can be applied retroactively and may allow taxpayers to obtain tax refunds related to expenditures for renovation projects completed in 2018 and 2019.

(Video) Cost Segregation Made Simple

Property and Sales Tax Considerations

Businesses can also use cost segregation studies to support the property tax or sales tax treatment of certain items. For example, a cost segregation study can be used to document the cost of a tax-exempt property. This would be helpful for manufacturers since many states exempt property used in manufacturing.

(Video) Cost Segregation Real Estate (BIG Advantages of Accelerated Depreciation!)

If your business decides to make changes based on a cost segregation study, please note that certain property may be treated differently for income tax and property tax purposes, and reporting mistakes can lead to double taxation. Suppose your state has a personal property tax and the business reclassifies certain building components as personal property for income tax purposes. If the business reports these items to the state as taxable personal property, but state law treats them as part of the real estate for real property tax purposes, they may be taxed twice: once as personal property and once as real property.

To avoid double taxation, be sure you have systems in place to track the costs of these items separately for income tax and property tax purposes.

Is a Cost Segregation Study Right for You?

Cost segregation studies may yield substantial benefits, but they’re not right for every business. Depreciation can result in significant tax savings when properly utilized. Cost segregation studies, bonus depreciation, and Section 179 expensing are all ways that your business can benefit.

To find out whether a study would be worthwhile, consult your tax advisor to do an initial evaluation to assess the potential tax savings and discuss the possible interplay that may prove beneficial depending on your situation.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.

(Video) Cost Segregation Techniques You Should Apply Today to Reduce Taxes


How much can cost segregation study save in taxes? ›

A cost segregation study is a federal income tax tool that increases your near-term cash flow by deferring taxes. With a cost segregation analysis, you could be able to write off up to 30-35% of your building's original purchase price in the first year!

How do I record cost segregation on my tax return? ›

The Form 3115 is used to request a change in accounting method from the IRS. Unless a property owner applies cost segregation the first year a building is placed in service, implementing a study will require filing a Form 3115.

Is it worth doing a cost segregation study? ›

Cost Segregation is an extremely valuable tax planning tool that provides significant savings to real estate owners by increasing cash flows through accelerating depreciation deductions.

Does the IRS require a cost segregation study? ›

A: The IRS requires engineering-based cost segregation studies. Your study should be conducted by a firm that demonstrates expertise in engineering, construction, tax law and accounting principles.

Does cost segregation help with my personal income tax? ›

Cost segregation allows you to separate the components of the property that depreciate faster. This helps reduce your tax liability and increase your cash flow. It also allows the use of bonus depreciation and Section 179 expensing for property components that may not otherwise qualify for these deductions.

How do you calculate accelerated depreciation? ›

Accelerated depreciation methods
  1. Sum of the Years' Digits Depreciation = Depreciable Cost x (Remaining Useful Life / Sum of Years' Digits)
  2. Sum of the Years' Digits = (Useful Life x (Useful Life + 1)) / 2.
  3. Double Declining Depreciation = 2 x Straight-Line Depreciation Rate x Value at Beginning of the Year.

Can you amend a tax return for a cost segregation study? ›

Can I amend a return for cost segregation from last year? Once an accounting method is established after filing two tax returns, you are required to file a 3115 to correct depreciation. If the property was acquired last year, you can amend last year's return to claim missed deductions.

Can you amend a tax return for depreciation? ›

Depreciation errors are corrected by either filing an amended return or filing a change in accounting method form.

What is the average cost of a cost segregation study? ›

How much will a Cost Segregation study cost? The fee for a Cost Segregation study will range depending on the building size, building type, number of tenants, and other physical characteristics. Typically fees can range from $5,000 to $15,000.

Can a CPA do a cost segregation study? ›

A cost segregation study, performed by qualified engineers and/or certified public accountants (CPAs), follows the Internal Revenue Code and the Unit of Property rules to further segment the building into Personal Property and Land Improvements categories.

What is the average cost segregation percentage? ›

The average cost segregation study allocates between 20% and 40% of depreciable costs from 39 years to a shorter life of 15, 7 or 5 years.

What assets are eligible for 100% bonus depreciation? ›

What qualifies for bonus depreciation?
  • Modified Accelerated Cost Recovery System (MACRS) property with a recovery period of 20 years or less. ...
  • Depreciable computer software.
  • Water utility property.
  • Qualified leasehold improvement property like any improvement to the interior portion of a nonresidential building.
Jan 23, 2023

How do I opt out of 100 bonus depreciation? ›

To make an election, attach a statement to your timely filed return (including extensions) indicating the class of property for which you are making the election and that, for such class, you are not to claim any special depreciation allowance.

Do you have to take bonus depreciation on all assets? ›

If you purchase depreciable property in your business, depreciating the property isn't optional–it's required. But bonus depreciation isn't mandatory. If you purchase property that qualifies for bonus depreciation, and for whatever reason don't want to write off 100% of the cost, you can elect not to take it.

Can cost segregation offset income? ›

Conducting a cost segregation study creates a non-passive loss that you can use to offset active income. If the loss is large enough, it can be carried over into future years. That means even if you reduce your taxable income to zero or hit excess business loss limits, you can still recognize losses in future years.

Can cost segregation offset ordinary income? ›

The net result is that cost segregation allows for much faster depreciation, thereby increasing overall tax savings! If your AGI is below $100k, K1 losses can directly offset W2 income.

Which tax is best for poor citizens? ›

In the United States, the historical favorite is the progressive tax. Progressive tax systems have tiered tax rates that charge higher income individuals higher percentages of their income and offer the lowest rates to those with the lowest incomes.

What is the tax rate for accelerated depreciation? ›

Accelerated depreciation provides much more tax benefit to investments in equipment, which benefit from effective tax rates between 4 and 15 percent lower. The effective tax rate on buildings, on the other hand, generally drops by 4 percent or less.

Does accelerated depreciation result in less taxes? ›

When a business includes accelerated depreciation on an income tax return, this reduces the amount of taxable income early in the life of a fixed asset. However, this leaves a reduced amount of depreciation that can be charged later in the life of the asset, which results in more taxable income in later years.

How is accelerated depreciation used for tax purposes? ›

Accelerated depreciation affects taxes by allowing businesses to deduct a larger portion of the cost of an asset in the early years of ownership. This results in a lower tax bill in the short term but may result in a higher tax bill in the long term when the asset is sold.

Is it a red flag to amend a tax return? ›

Amending a return is not unusual and it doesn't raise any red flags with the IRS. In fact, the IRS doesn't want you to overpay or underpay your taxes because of mistakes you make on the original return you file.

Can I amend for missed depreciation? ›

Depreciation errors are corrected by either filing an amended return or filing a change in accounting method form.

What is the average cost to amend a tax return? ›

If we made an error, we amend at no charge. If we prepared the return, but you failed to provide us with complete and accurate information, then we charge for additional forms needed to prepare the corrected return. The minimum charge is typically about $400 - $600.

How do you lower taxes with depreciation? ›

By charting the decrease in the value of an asset or assets, depreciation reduces the amount of taxes a company or business pays via tax deductions. A company's depreciation expense reduces the amount of earnings on which taxes are based, thus reducing the amount of taxes owed.

What happens if you forgot to record depreciation? ›

If the business fails to make a depreciation entry during any given tax period, the business must correct the depreciation deduction by filing an amended return. The amended return must correct the depreciation amount, as well as any other figures that become misconstrued due to the error.

Can depreciation offset regular income? ›

The IRS does not allow us to mix passive losses with ordinary income. So, it is not possible to offset ordinary income with rental property losses, whether those losses are due to depreciation or operating expenses.

How do you pass a tax audit? ›

In an audit, you must convince the IRS that you reported all of your income and were entitled to all credits, deductions, and exemptions.
  1. Delay the audit. ...
  2. Don't host the audit. ...
  3. Have realistic expectations. ...
  4. Be brief. ...
  5. Don't offer other years' returns. ...
  6. Reconstruct records. ...
  7. Negotiate. ...
  8. Know your rights.

How do I get out of a tax audit? ›

Within 30 days, you can request an appeal with the IRS Office of Appeals. After 30 days, the IRS will send you a letter, called a Statutory Notice of Deficiency. This letter closes the tax audit and allows you to petition the U.S. Tax Court.

How do I solve an IRS audit? ›

Send your request for audit reconsideration to the office that last corresponded with you
  1. A copy of your audit report (IRS Form 4549, Income Tax Examination Changes), if available.
  2. Copies of the new documentation that supports your position. Don't send original documents. Send copies.

What is the average cost segregation? ›

On average, a cost segregation study can allocate 20 – 40% of the depreciable cost basis of a property to an accelerated recovery period. Occasionally the allocation is much higher. *The results above are averages for illustrative purposes only and should not be relied upon for calculating depreciation.

Can you offset w2 income with depreciation? ›

First – Depreciation, bonus, or otherwise, only offsets passive income. Passive income includes rent from investment real estate, profits from ownership in a business you don't actively participate in, etc. It does not offset ordinary income like your W-2 income.

Does property depreciation reduce your taxable income? ›

Real estate depreciation is an important tool for rental property owners. It allows you to deduct the costs from your taxes of buying and improving a property over its useful life, and thus lowers your taxable income in the process.

What is the income limit for rental property depreciation? ›

What's the rental property depreciation income limit? The depreciation deduction can generally only be claimed by property owners who have a modified adjusted gross income of $100,000 per year or less. Your modified adjusted gross income represents the amount of taxable income you'll have each year.

How often can you do a cost segregation study? ›

A Cost Segregation study can be completed any time after the purchase, remodel or construction of a property. However, the optimum time for a study for new owners is during the year a building is constructed, purchased or remodeled.

How do I deduct depreciation on a rental property? ›

To calculate the annual amount of depreciation on a property, you divide the cost basis by the property's useful life. In our example, let's use our existing cost basis of $206,000 and divide by the GDS life span of 27.5 years. It works out to being able to deduct $7,490.91 per year or 3.6% of the loan amount.

What are the disadvantages of cost segregation? ›

The process will entail some cost and time. A study could cost as much as $20,000 or more, depending on the location, age of the property, and whether the building is residential or nonresidential. The study could take a month or more to complete.

Is cost segregation the same as accelerated depreciation? ›

Cost segregation is a tax strategy that converts traditional depreciation into asset-based depreciation. This strategy can accelerate the depreciation rate, lowering the owner or investor's annual taxable income.

What type of income does depreciation offset? ›

The depreciation deductions are limited to the amount of rental income (passive income) and cannot be used to reduce ordinary income. So, if enough passive income is not available as an offset, the passive loss will carry forward into the following tax year as a Net Operating Loss (NOL).

What is cost segregation for dummies? ›

Simply, cost segregation is a tax deferral strategy that identifies assets within a building that can be depreciated over a shorter period than the 39-year standard method. It can identify substantial tax-saving opportunities for taxpayers who have constructed, purchased, or renovated a facility.

What type of property is best for cost segregation? ›

Cost segregation has the potential to benefit any property. However, owners of larger multifamily or commercial properties will benefit the most from these studies and should definitely consider having a study done.

How long does a cost segregation study take? ›

A typical cost segregation study takes between four and eight weeks to complete from the time all relevant information is collected.


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