Cost segregation creates a unique opportunity for building owners to minimize taxable income by maximizing depreciation expense in the year or years following the purchase or development of a building.

Cost segregation is a method of allocating building costs to components with a shorter depreciable life, which increases the depreciation deduction in the early years of owning the property.  The default depreciation period is 27.5 years for residential buildings and 39 years for commercial buildings.  For example, if you purchase a commercial building for $1,500,000 and allocate $500,000 to land, the remaining $1,000,000 will be depreciated evenly over 39 years.  

With a cost segregation study, the various components that make up the building are separately itemized, and a portion of the cost of the building is allocated to each component.  Building components may include carpet or floor covering, HVAC, electrical, plumbing, furnishings, equipment, signage, and exterior improvements such as landscaping and site work. Once segregated, some components may qualify for an immediate depreciation deduction in the first year, while other components may be depreciable over 5, 7, or 15 years, and others may retain the 27.5 or 39-year life.

If you’ve owned a property for several years and decide to conduct a cost segregation study, you are allowed to catch up the depreciation deduction for multiple years in the year the study is performed.

Can you do the study yourself? The IRS audit guide does not specify specific requirements but says it should be a “quality cost segregation report” supported by a “quality cost segregation study.” Prior rulings mention “qualified professionals” with relative experience in design, construction, auditing, and estimating.  This is not a “do it yourself” project.

If you’ve constructed or purchased real estate for use in your business in the last few years, it’s probably worth a conversation to determine if a cost segregation study would be beneficial.