Cost Segregation Study: Meaning, Limitations, and Example

A cost segregation study is a tax planning strategy that allows real estate owners to accelerate depreciation deductions by reclassifying components of a property into shorter useful life categories. Instead of depreciating the entire property over 27.5 or 39 years (for residential and commercial property, respectively), certain assets like flooring, cabinetry, electrical systems, or landscaping can be depreciated over 5, 7, or 15 years.

The goal is to increase near-term cash flow by deferring taxes, making cost segregation especially valuable for investors who have recently acquired, renovated, or constructed income-producing real estate.

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How It Works

When you purchase or improve a property, the IRS typically treats the entire structure as a single asset. But in reality, not all building components wear out at the same rate. A cost segregation study—conducted by engineers and tax professionals identifies and values these components separately.

By breaking down a property into personal property (e.g., fixtures, appliances, carpet) and land improvements (e.g., sidewalks, parking lots), you can allocate a significant portion of the cost to faster depreciation schedules. This creates larger deductions in the early years, reducing taxable income and boosting cash flow.

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Limitations and Considerations

Despite its benefits, a cost segregation study isn’t right for every investor. Some limitations include:

• Upfront cost: A professionally conducted study can cost between £5,000 and £15,000, depending on the property size and complexity.

• Audit risk: Improper classification or lack of documentation can draw scrutiny from the IRS. Only use experienced professionals with detailed, defensible reports.

• Recapture tax: If the property is sold, previously accelerated depreciation may be subject to depreciation recapture, potentially increasing tax liabilities at sale.

  
  

For smaller properties, the cost may outweigh the benefit unless paired with bonus depreciation or other strategic goals.

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Real-World Example

Consider a commercial property purchased for £2 million. Without cost segregation, the owner would depreciate the building over 39 years. But with a cost segregation study, £400,000 is reclassified into 5-year property, and £250,000 into 15-year property. This creates substantial early-year deductions—often exceeding £100,000 in the first year alone.

This immediate tax shelter allows the investor to reinvest savings into more acquisitions, property improvements, or loan repayments, all while preserving long-term value.

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Final Thoughts

A cost segregation study is one of the most effective but underused tax strategies for real estate investors and owners. When applied correctly, it can significantly reduce current tax burdens, unlock early cash flow, and enhance ROI. However, like all tax planning tools, it must be used carefully, with full documentation and professional oversight. Before moving forward, consult with your CPA or tax advisor to ensure it fits your investment timeline, property type, and financial objectives.