The following Q&A was completed as part of our conversational Commercial Real Estate FAQ Interview Series, we hope you find it helpful.
While not worthwhile on all properties or investments, cost segregation is an ideal way to accelerate your depreciation if you’re planning to hold the property for a number of years and that property is worth more than $3-5 million. With cost segregation, your property is analyzed by a professional CPA to determine your construction budget, acquisition of the building, and determine the value of the building and all of its components. You get a detailed view of how costs are segregated throughout the property, and how all of these various components depreciate individually.
What is cost segregation? So, cost segregation is the process of doing a formal study by a CPA firm in order to determine what kind of depreciation each item inside your construction project is eligible for. So, I’ll give you an example. Let’s say you have a $10 million industrial project that you’re building, well you could hire a CPA to go in there and look at your construction budget, or even just your acquisition of the building, and determine okay this much of the value of the building is attributable to the HVAC system. This much is attributable to the doors, the ceiling tiles. This much money should be allocated to, you know, whatever; whatever parts and pieces, the landscaping, the this, the that, whatever. And so at the end of it you get a detailed breakdown of kind of how all the costs are segregated, meaning broken out. And what that allows you to do is instead of depreciating everything that’s the building, because you can’t depreciate the land. So let’s say you have a $10 million project, and you spent $2 million on the land, now you’d have a depreciable basis of $8 million, right? Because whatever is not the land is the building, and whatever is the building is depreciable over 27.5 years for residential type uses, and 39 years for commercial property. So you would look at the costs of how are these different parts and pieces of the building divided up, and your CPA would say “Well, the HVAC system you can depreciate that over, let’s say, 7 years. And you can depreciate the roof over 5 years. And you can depreciate the carpeting over 12 years.” I’m just making up numbers, but you get the point. And what that does is it allows you to actually accelerate some portion of that $8 million of the quote/unquote building that your depreciable base is, and accelerate it so you can take more of that depreciation and earlier years.
So it’s an acceleration of your tax benefit. You would get all of that depreciation over let’s say the 39 years, but let’s say you want to take a big chunk of it next 3 or 4 years, you would do a cost segregation study with a CPA and they would basically figure it out. Now it can be pretty expensive to do these cost segregation studies, because they have to document everything and prove that they’re not just making up numbers, so you have to have a pretty big property in order to justify it. I would say probably north of $3-5 million minimum to make it worth doing a cost seg. So, that’s really what a cost segregation study is and it only should be done and used if you plan on holding the building at least 5 or 10 years because if you just hold the building for a couple of years and you do the accelerated depreciation, you’re just going to end up paying depreciation recapture tax when you sell it, and that’s not going to serve you anything. So, anyway, those are the tips that at least my exposure of cost seg