Even with the pandemic, economic ups and downs, and rising interest rates, commercial real estate remains an appealing investment. From favorable prices and financing through equity appreciation and income potential, savvy investors can reap a range of rewards from owning commercial property. But there’s one advantage that’s a primary driver for most commercial real estate investors — the opportunity to optimize available tax advantages and improve their return on investment.

The purchase, construction or renovation of a commercial property creates a building asset that’s classified as a 39- or 27.5-year property. Using what’s known as the straight-line method, property owners are then able to take an equal portion of the purchase as a taxable income deduction for each year of the designated schedule. While this method accounts for the depreciation of the asset over the life of the property, conducting a cost segregation study enables investors to be more precise in how they recognize asset depreciation and gain additional tax advantages in the process.

What’s a cost segregation study?

A cost segregation study is a strategic tax planning tool that enables commercial property owners to take more depreciation deductions, thereby reducing their tax liabilities in the early years of ownership. This is achieved by segregating the costs of tangible personal property, other tangible property, indirect costs, and land improvements from building and improvement costs. Separating the costs typically results in significantly shorter depreciation periods of five, seven or 15 years for specific components.

Property owners who construct, renovate or acquire commercial or residential real estate see the most benefit from cost segregation, but any company that makes building upgrades that exceed $500,000 is typically a good candidate for cost segregation. Commercial properties can range from retail, offices and hotels to warehouses, apartments and mixed-use developments.

Cost segregation studies are conducted by licensed engineers and tax professionals who are knowledgeable about construction processes, property classifications and tax laws. These experts inspect the property to identify and assess the different components, such as the roof, plumbing and electrical wiring. They also access property records, building inspections, construction costs and blueprints. After the detailed analysis, different components are each assigned a “useful life,” which determines the depreciation schedule for the component. Then, the tax professional works with the property owners to determine how to best use the accelerated depreciation deductions to achieve the maximum tax benefit.

The best time to get a cost segregation study

To optimize the available tax benefits, conducting a cost segregation study within the first year following the construction, purchase or renovation of a property is ideal.

However, investors can also opt to conduct a look-back study on buildings built, acquired or renovated in prior years. A look-back cost segregation study enables property owners to claim depreciation not previously deducted for up to 10 years in many cases. The catch-up deduction, which equals the difference between what was depreciated and what could have been depreciated based on the cost segregation study, is taken in a single year. In addition, the catch-up deductions can be claimed on the next filed tax return without having to amend previous returns.

The business impact of a cost segregation study can be significant

Check out this video that explains the tax implications for a commercial property that undergoes a cost segregation study.

By strategically accelerating the depreciation to achieve tax savings, the investor creates increased cash flow — even with the costs of the study factored in. On average, the net present value savings produce a return on investment of $15 of tax savings for each dollar spent in fees.

Along with the tax advantages, the detailed analysis of the property by independent third-party experts provides valuable insights into the property, as well as documentation that meets IRS requirements and withstands review. The commercial real estate experts at CBIZ can help you identify the tax savings opportunities for your properties and conduct a cost segregation study to maximize the use of accelerated depreciation.

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