As a business owner or real estate investor, you’re always looking for smart strategies to improve cash flow and minimize your tax burden. One of the most powerful—and often underutilized—tools in your arsenal is a cost segregation study.
At Shah Tax & Accounting Services, we believe that understanding your options is the first step toward building a stronger financial future. That’s why we’re breaking down what cost segregation is, how it works, and who stands to benefit most from this valuable strategy.
What is Cost Segregation?
In simple terms, cost segregation is a tax planning strategy that involves accelerating your depreciation deductions.
When you purchase or build a piece of real estate—whether it’s an office building, a factory, or an apartment complex—the IRS requires you to depreciate the value of the property over a long period: 27.5 years for residential property and 39 years for commercial property.
But here’s the clever part: a building isn’t just one big, monolithic asset. It’s a collection of many different components, from the structural frame to the light fixtures, carpeting, and even the landscaping outside.
A cost segregation study is a detailed engineering analysis that identifies and reclassifies these components into shorter-lived asset classes. This means instead of waiting 39 years to fully depreciate the cost of that new specialty lighting, you could potentially depreciate it over just five years.
The result? You get to claim larger deductions in the early years of ownership, which reduces your current taxable income and puts more cash back in your pocket.
Who Benefits Most?
Cost segregation is not a one-size-fits-all solution, but it can be a game-changer for certain taxpayers. You’re likely an ideal candidate if you are:
- An owner of commercial or income-producing real estate: This includes office buildings, manufacturing facilities, restaurants, hotels, and apartment complexes.
- A high-income taxpayer: The increased deductions are most impactful when you have sufficient taxable income to offset.
- A taxpayer with a significant property investment: While there’s no hard-and-fast rule, properties with a cost basis of at least $500,000 to $1,000,000 typically offer the greatest return on investment for a cost segregation study.
- Planning to hold the property for several years: Cost segregation accelerates deductions, but it doesn’t create new ones. If you plan to sell the property quickly, the benefits may not outweigh the costs.
A Look at Local Implications: NJ, PA, and NY
While cost segregation is a federal tax strategy, it’s important to understand how your state’s tax laws might affect the outcome. Below are examples of potential state impacts for NJ, NY and PA. If you have property in other states, we can help you there too.
- New Jersey: The Garden State generally aligns with federal depreciation rules and respects cost segregation studies. However, it “decouples” from federal bonus depreciation, meaning you’ll need to make adjustments when filing your state taxes.
- New York: Similar to New Jersey, New York generally conforms to federal classifications but has its own rules for bonus depreciation and Section 179 expensing. This means separate calculations are necessary for state purposes.
- Pennsylvania: The Keystone State has a unique and important rule to be aware of. For property placed in service after September 27, 2017, Pennsylvania generally disallows depreciation until the asset is sold or disposed of. This means the accelerated depreciation benefits of cost segregation are essentially nullified at the state level, though the federal benefits remain.
The Catch: Passive Activity Loss (PAL) Rules
Even with the powerful deductions from cost segregation, you must consider the Passive Activity Loss (PAL) rules. For most rental real estate activities, losses can only offset passive income. If you don’t have enough passive income, the losses are “suspended” and carried forward to future years.
However, there are a couple of key exceptions:
- The Real Estate Professional Exception: If you qualify as a real estate professional, your rental activities are considered non-passive, allowing you to use losses to offset any income, including wages.
- The $25,000 Special Allowance: For those who don’t qualify as a real estate professional but “actively participate” in their rental activities, you may be able to use up to $25,000 of passive losses to offset other income, subject to certain income limits.
Is Cost Segregation Right for You?
Cost segregation is a powerful and legitimate tax planning strategy. By accelerating depreciation, you can significantly reduce your tax liability and free up cash for other investments, business operations, or debt reduction.
However, the strategy requires careful analysis and a thorough understanding of federal and state tax laws. This is where a trusted tax advisor comes in.
If you own commercial or income-producing real estate and are interested in exploring whether a cost segregation study is right for your financial situation, contact the experts at Shah Tax & Accounting Services today. We’ll help you navigate the complexities and develop a strategy that works for you.