5 Reasons To Avoid a Cost Segregation Study

Cost segregation can be a powerful tax strategy for real estate investors, but it's not always the right move for every property owner. Below, we’ll discuss what a cost segregation study is and key variables to consider that may make it unwise.

What is a Cost Segregation Study?

A cost segregation study is a tax strategy used by real estate investors to accelerate property depreciation deductions. Instead of depreciating the entire building over 27.5 or 39 years (the standard IRS schedule), the study breaks down the property into individual components—like flooring, lighting, or landscaping—that can be depreciated over shorter time frames (5, 7, or 15 years). This can significantly increase tax deductions in the early years of ownership, improving cash flow.

In my experience, cost seg studies typically cost $4k-$7k. However, this cost may increase depending on the size of the property.

1. Low Property Value

Cost segregation studies tend to offer the greatest benefit for properties with a basis of $500,000 or more. If your rental property is valued significantly lower than that, the tax savings may not justify the cost of the study.

The argument for a cost seg study increases as the property value increases.

2. Short-Term Hold Period

If you plan to sell the property in just a few years, the benefits of accelerated depreciation might be reversed through depreciation recapture. This could offset much of the upfront tax savings, making the study less advantageous in the long run.

Depreciation recapture is a tax rule that applies when you sell a property you've depreciated for tax purposes. When the property is sold, the IRS may "recapture" some of the tax benefits you received from depreciation by taxing a portion of your gain at a higher rate, typically up to 25%.

In simple terms, if you claimed depreciation deductions during ownership, you may have to pay taxes on those deductions when you sell, even if the property's value hasn't increased overall. It's an essential factor to consider when using any accelerated depreciation strategy surrounding an asset you may sell.

3. Passive Activity Loss Limitations

If you're not a real estate professional for tax purposes and your rental activity is passive, large depreciation deductions might not help much in the current year. This is because the losses created by passive activities can only be deducted against the income from that business and not deducted from your earned income.

However, suppose you or your spouse qualify as a real estate professional managing the property as part of your primary source of income and hourly efforts throughout the year. In that case, you may be able to deduct the losses against your earned income.

4. Low Tax Bracket

Assuming you can qualify as a real estate professional and deduct losses against your earned income, the deductions against a high income in the 32 %+ brackets can be valuable. However, the lower your tax bracket is, the less benefit you will receive, and the greater the cost of the study will impact your return on investment.

5. Large Cash Reserves

Cost seg studies can be used like a savings account. If you have plenty of cash, it may be worth saving this cost seg study as a lever you can pull down the road to access cash when it may be more beneficial. Whether this is in a down market to invest the proceeds or you lost your job, it can be a nice rainy day fund, although not very liquid.

Conclusion

Cost segregation can be a smart move for the right investor, but it’s not one-size-fits-all. Always consult your CPA or tax advisor to determine whether it makes sense based on your unique investment goals and tax situation.