What is Cost Segregation?

Cost Segregation Overview

By default, commercial property is depreciated over 39 years. A cost segregation study identifies components with shorter depreciable lives. By moving building components into more favorable classifications, cost segregation generates large deductions in the early years of ownership. For any real estate investor or business owner seeking additional deductions against their income, cost segregation is worth considering.

Our firm provides an engineering-based study which the client’s tax professional can use to implement these more favorable asset classifications. Our studies rely on building plans, construction documents, appraisals, and photos of the property. By utilizing bonus depreciation, a cost segregation study on a $1 million office building could result in $68,570 in tax savings. Taxpayers can also elect out of bonus depreciation and receive increased depreciation deductions over the first fifteen years of building ownership instead of in the first year only.

Many business owners and real estate investors who have not taken advantage of cost segregation. We provide a no‐cost evaluation of the client property to determine whether there will be a tax benefit. To provide the evaluation, we request a copy of the client’s depreciation schedule (for properties that have been in service for over one year), property type, and address. For newer properties, we request the purchase price, purchase date, property type, and address.

Cost Segregation History

Prior to cost segregation, one of the primary methods of increasing real estate deductions was a method called component depreciation. Component depreciation involved dividing the cost of a building among its various systems such as electrical, HVAC, and plumbing. Each building system had a depreciable life that was shorter than the building as a whole, so component depreciation allowed for larger depreciation deductions in the early years of building ownership. Component depreciation was eliminated in the 1980s once the modern depreciation methods Accelerated Cost Recovery System and Modified Accelerated Cost Recovery Systems were established. 

Under these new depreciation methods, there were few clearly legal methods of increasing depreciation expenses on real estate. The Hospital Corporation of America attempted to increase depreciation expenses by classifying parts of a hospital building as Section 1245 property, also known as tangible personal property. The IRS Commissioner took issue with this classification and claimed that what HCA did constituted component depreciation, which was no longer allowed under the new tax law.

The resulting court case, Hospital Corporation of America and Subsidiaries v. Commissioner, was decided in favor of HCA in 1997. The ruling allowed for certain building components to be classified as tangible personal property under MACRS. Cost segregation has existed ever since as a legal method of increasing depreciation deductions on real estate.

Since the process of allocating building cost from Section 1250 property (structural components of building) to Section 1245 property can be complex, cost segregation studies have developed as a way for taxpayers to reliably take advantage of the tax savings available through cost segregation while remaining in full compliance with the law. The IRS has even released a publication called the Cost Segregation Audit Techniques Guide that provides guidelines for how to appropriately execute a cost segregation study.

The information on this page is provided for informational purposes only and does not constitute tax advice.