How Cost Seg Works
A concise, practical explanation of how cost segregation delivers tax benefits and the typical process involved.
TLDR: With Cost Segregation, a property owner can get 2% - 10% of their purchase price back as cash in the form of tax reductions in year 1 after purchase (and reduce taxes in future years).
Background On Depreciation
To explain cost seg, we first need to explain the concept of depreciation. Depreciation is the accounting method to reduce the value of an asset over time as it ages. Section 167 of the tax code allows the taxpayer to deduct depreciation for the “exhaustion, wear and tear (including a reasonable allowance for obsolescence)” for property used in its business or for property held for the production of income.
The tax code (and the IRS) allows property owners to use depreciation deductions to offset income, lowering taxable income and the taxes you pay each year.
Typically, taxpayers depreciate their entire property (excluding land, which is not depreciable), over 27.5 years for residential properties (excluding short-term rentals), or 39 years for commercial properties, and using the straight-line method. However, this assumes all components have the same useful life — which is rarely true.
The Role Of Cost Segregation
Bundling all of the components of a property into a 27.5 year or 39 year bucket is overly simplistic and does not reflect reality.
The IRS recognizes that different components of a property have different useful lives. For example, components such as carpet, cabinetry, specialty electrical, and land improvements (sidewalks, fencing) typically require more frequent repair or replacement, and so have shorter useful lives (e.g., 5, 7, or 15 years). Structural components of a building, such as walls and roofs, have longer useful lives (e.g., 27.5 or 39 years).
A cost segregation study is a detailed engineering analysis that identifies and reclassifies components of your property into the appropriate useful life buckets for tax purposes. Our engineering team reviews the details of your property - including the appraisal, property condition report, site survey, construction drawings, construction/renovation costs, etc. - and builds a detailed, engineering-based replacement cost estimate for each component of the property. This allocates a portion of the cost of your property into shorter useful life buckets.
The result of a cost segregation study is accelerated depreciation to the property owner - aka more depreciation in the earlier years. By allocating costs to asset classes with shorter tax depreciation periods, you can claim more depreciation deductions in the initial years of ownership. If you have taxable income to offset, this can result in significant tax savings and increased cash flow. We usually see successful investors use this cash flow to reinvest in more properties, pay down debt, or make other investments.
Bonus Depreciation
Bonus depreciation (technically called the “Special Depreciation Allowance for Qualified Property” by the IRS in the tax code) is a misleading name and can cause confusion. Bonus depreciation does not create more overall depreciation - instead it further accelerates the depreciation that can be deducted in year 1. “Accelerated depreciation” would probably be a more descriptive name. Bonus depreciation only applies to the components and costs in the shorter life tax categories (i.e., the 5 year, 7 year, and 15 year property).
Depending on when your property was acquired, constructed, and placed into service, you may be eligible to claim up to 100% bonus depreciation. This means you could deduct 100% of the costs of the reclassified components in the shorter life tax categories (i.e., the 5 year, 7 year, and 15 year property) in year 1. So, instead of recognizing depreciation deductions equally over 5 years, you will recognize 100% of them in year 1.
Bonus depreciation significantly accelerates your depreciation, increasing the potential tax savings from cost segregation materially.
Cost Seg Example
| Purchase price for a short term rental property | $1,000,000 |
| % of purchase price allocated to land (which is non-depreciable) | 20% |
| Depreciable basis | $800,000 |
| % of depreciable basis reclassified into shorter life categories with a cost seg | ≈ 25% |
| Assets eligible for Year 1 100% bonus depreciation with a cost seg | ≈ $200,000 |
| Year 1 tax savings at a 37% federal income tax rate with a cost seg | ≈ $74,000 |
Higher depreciation → lower taxable income → improved cash flow
Note: This estimate is provided for informational purposes; actual results will depend on the specific features of your property (e.g., quality of the property, condition, year of purchase, renovation work, location, etc.).
Why Choose MVO
MVO helps real asset owners navigate the complex worlds of tax credits and incentives. Our team has 20+ years of experience performing cost segregation studies.
We are unique in the market by offering a full range of cost segregation services, from DIY studies for single-family residential properties (under our sister brandCost Seg EZ) to fully engineered studies for more complex properties and situations. We focus on delivering the highest quality reports, at a price that ensures a high ROI.
Estimate your tax savings here, or schedule a free consultation here and we can help you.
Frequently Asked Questions
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