Real estate tax play fuels investor demand

Real estate investors are increasingly turning to cost segregation studies as a way to accelerate depreciation and improve cash flow. The technique, often called a “cost seg,” separates a building into components that can be depreciated more quickly than the standard Internal Revenue Service (IRS) timelines of 27.5 years for residential property and 39 years for commercial property.

Instead of deducting the entire cost of a building evenly over decades, engineers analyze internal and external elements such as flooring, electrical systems, plumbing and HVAC. They then reclassify certain items into shorter depreciation categories of five, seven or 15 years. In some cases, even electrical outlets can be treated as short‑life assets rather than 39‑year property.

According to CPA Kristel Espinosa, this acceleration can dramatically increase first‑year deductions. Using a $1 million commercial building as an example, she noted that standard depreciation would produce an initial deduction of about $25,600. With a cost segregation study and bonus depreciation, an investor could potentially deduct hundreds of thousands of dollars upfront.

By front‑loading depreciation, investors can reduce current tax liability and free up capital to reinvest. Espinosa said that, as a general rule, a cost segregation study typically allows 20% to 40% of a building’s cost to be reclassified into shorter depreciation periods. Depending on the results and the investor’s tax profile, that can generate first‑year tax savings of $50,000 to more than $150,000 per $1 million of building cost.

In one example she cited, a client purchasing a $15 million commercial building was able to reclassify $5 million into shorter‑life assets that qualified for bonus depreciation. At a 37% federal tax rate, that translated to roughly $1.11 million in federal tax savings before state taxes. In another case, a client paid about $10,000 for a study and saved around $1.8 million in taxes, which Espinosa described as not unusual for high‑income investors in top tax brackets with large portfolios.

The large deductions can put investors into a loss position on paper, even when their properties are cash‑flow positive. Espinosa noted that if losses are not fully used in the current year, they can be carried forward, potentially sheltering rental income from the same property for years.

Cost segregation studies are not inexpensive. They generally cost several thousand dollars and can take one to two months to complete. Whether they make sense depends heavily on the property’s size, purchase price and the owner’s tax situation. Espinosa said the strategy often works best for higher‑income investors who own commercial properties or large portfolios.

Depreciation normally offsets passive income, such as rents, but not active income like wages. However, investors who qualify as real estate professionals under IRS rules can use rental losses to offset active income. Jill Green, a full‑time physician who invests in real estate with her husband, has used tax savings from cost segregation to expand their portfolio by roughly one property per year. In their case, Green’s spouse qualifies for real estate professional status, which makes their cost segregation studies especially powerful because accelerated depreciation can offset active income.

Espinosa contrasted this with smaller or short‑term holdings. Green, for example, decided against ordering a study on a $123,000 property, concluding that it did not make financial sense, particularly given a plan to sell it quickly. The benefits are generally greater for commercial assets, which have more components to reclassify, and for properties with higher purchase prices and longer intended holding periods.

Advisers stress that cost segregation requires careful execution. Espinosa recommends that investors work closely with experienced certified public accountants and cost segregation specialists. The studies rely on detailed engineering reports that break down building components and support the reclassification decisions.

Those reports need to be retained in case of an audit, as the IRS may scrutinize aggressive depreciation claims. While Espinosa described cost segregation as “powerful,” she emphasized that it is not appropriate for every property and that improper use could create issues if examined by tax authorities.

For investors willing to absorb the upfront cost and complexity, cost segregation can be a significant tool in managing taxable income and funding growth through tax savings. For others, particularly those with smaller or shorter‑term holdings, standard depreciation may remain the more practical route.