Cost Segregation & Bonus Depreciation: The Race Against the Tax Phase-Out Clock
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Result: Even with Bonus Depreciation fading to 40%, Cost Segregation still delivers 4.7x more tax savings in the first year.
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Cost Segregation & Bonus Depreciation: The Race Against the Tax Phase-Out Clock
COACHING POINTS
- The Power: Normally, you must depreciate commercial real estate over 39 years. A Cost Segregation Study identifies components (lights, carpet, pavement) that can be depreciated in 5, 7, or 15 years. This creates massive paper losses in Year 1.
- The Urgency: The TCJA “Bonus Depreciation” (allowing 100% write-off of these short-life assets) is fading. It drops by 20% each year: 60% in 2024, 40% in 2025. The window is closing.
- The Payoff: By accelerating depreciation, you reduce your current taxable income today (when money is worth more) and defer taxes to the distant future (when money is worth less due to inflation).
In real estate, “Depreciation” is a magic word. It is a non-cash expense that lowers your tax bill without lowering your bank balance. But standard depreciation is slow. Cost Segregation is the turbocharger. By reclassifying parts of your building as “Personal Property,” you can unlock hundreds of thousands in deductions now.
[Image of cost segregation asset reclassification pie chart]
The “Time Value of Tax” Math
Impact of accelerating $500,000 of depreciation.
- Standard (Straight Line): Deduct $12,820/year for 39 years. Tax Savings @ 37% = ~$4,700/year.
- Cost Seg (Bonus 60%): Deduct ~$300,000 in Year 1. Tax Savings @ 37% = ~$111,000 in Year 1.
- The Win: You get $111k cash back today to reinvest. The “Opportunity Cost” of waiting 39 years for that money is enormous. Authority: IRS Pub 946
What-If Scenario: Purchasing a $2.5M Commercial Building
Assumptions: Land Value $500k. Building Basis $2M. Study identifies 25% ($500k) as 5-Year Property.
| Metric | No Study (39 Yrs) | Cost Seg (40% Bonus – 2025) |
|---|---|---|
| Year 1 Depreciation | $51,282 | $200,000 (Bonus) + Regular |
| Total Year 1 Deduction | ~$51,000 | ~$240,000 |
| Tax Savings (@37%) | $18,870 | $88,800 |
Visualizing the Deduction Cliff
*Figure 1: Depreciation Schedule. The Green spike (Cost Seg) shows the massive upfront benefit vs. the flat Red line (Standard).*
Execution Protocol
1
Screen Your Property
Not every property qualifies. Ideally, the building basis (purchase price minus land) should be $500,000+. Below this, the cost of the engineer’s study ($3k-$5k) might outweigh the tax benefit.
Not every property qualifies. Ideally, the building basis (purchase price minus land) should be $500,000+. Below this, the cost of the engineer’s study ($3k-$5k) might outweigh the tax benefit.
2
Hire a Qualified Firm
Do not guess. The IRS requires an engineering report. Use firms like KBKG, CSSI, or Madison Specs. They will provide a detailed report defending the reclassification of every electrical outlet and carpet square.
Do not guess. The IRS requires an engineering report. Use firms like KBKG, CSSI, or Madison Specs. They will provide a detailed report defending the reclassification of every electrical outlet and carpet square.
3
File Form 3115
If you’ve owned the building for years, you can do a “Look-Back” study. File Form 3115 (Change in Accounting Method) to claim all missed depreciation from previous years in the current year. No need to amend past returns.
If you’ve owned the building for years, you can do a “Look-Back” study. File Form 3115 (Change in Accounting Method) to claim all missed depreciation from previous years in the current year. No need to amend past returns.
COACHING DIRECTIVE
- Do This: If you are a Real Estate Professional (REPS) or have Passive Income (PALs) to offset. Or if you have a Short-Term Rental (STR) where losses are non-passive.
- Avoid This: If you plan to sell the property in < 2 years. You will have to pay "Recapture Tax" (up to 25%) on the accelerated depreciation, cancelling out the benefit. Cost Seg is a long-term hold strategy.
Frequently Asked Questions
What is a Cost Segregation Study?
It is an engineering-based analysis that reclassifies building components (usually depreciated over 27.5 or 39 years) into shorter-life assets (5, 7, or 15 years). Examples include carpeting, specialty lighting, fencing, and parking lots. This allows you to depreciate them much faster.
What is Bonus Depreciation?
It is a tax incentive that allows businesses to deduct a large percentage of the purchase price of eligible assets in the very first year. However, the rate is phasing out: 80% (2023), 60% (2024), 40% (2025), 20% (2026), and 0% (2027).
Is it worth the cost?
A study typically costs $5,000 to $15,000. However, on a $1M+ property, it often yields $50,000 to $100,000+ in immediate tax savings. If the tax benefit exceeds the fee by 3x-5x, it is mathematically irrational not to do it.
Disclaimer: Depreciation Recapture tax (25%) applies upon sale. The tax benefits of Cost Segregation are a deferral, not a permanent elimination, unless you 1031 Exchange or hold until death. Consult a CPA.
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