You’ve just purchased a commercial property to help your business grow. You’ve spent months planning, budgeting, and negotiating the loan.
Now, the space is yours—but beneath the excitement, you may not realize there are tax strategies you could use to strengthen your bottom line. Without them, you could miss early opportunities to improve cash flow and boost your tax savings.
A valuable yet often overlooked opportunity is the cost segregation study. This tax planning tool allows property owners and real estate investors to reclassify building assets for shorter depreciation schedules.
Instead of depreciating the full value of a commercial property over 39 years, specific components—like lighting, flooring, and landscaping—can be written off over 5, 7, or 15 years. This accelerates depreciation deductions, reduces tax liability, and frees up capital.
Let’s look at how this strategy works—starting with what a cost segregation study is, who benefits from it, and how to weigh the tax benefits against potential downsides.
What is a cost segregation study?
A cost segregation study is a tax strategy that identifies and reclassifies building components so they can be depreciated over shorter timeframes. Instead of grouping all property costs under a standard 27.5-year or 39-year schedule, this method breaks them down based on how long each part actually lasts.
Under IRS rules, commercial buildings are depreciated over 39 years, and residential rental properties over 27.5 years. But many parts of a property—such as flooring, interior finishes, and certain electrical or plumbing systems—don’t last that long and can qualify for shorter depreciation periods of 5, 7, or 15 years.
A cost segregation analysis separates these faster-depreciating items from the rest of the property, allowing for larger depreciation deductions in the earlier years of ownership.
The best part? Accelerating depreciation deductions reduces taxable income and improves cash flow.
Qualifying assets often include:
- Flooring and carpeting.
- Decorative millwork or cabinetry.
- Accent lighting and certain electrical components.
- Outdoor features like sidewalks, signage, and landscaping.
This strategy applies to newly purchased, constructed, or renovated properties and is especially valuable for businesses looking to reinvest and grow.
Who should consider a cost segregation study?
Cost segregation benefits businesses and individuals with significant real estate investments. That includes:
- Property owners with commercial or rental properties valued at $200,000 or more.
- Real estate investors aim to increase the after-tax return on their holdings.
- Entrepreneurs seeking ways to optimize tax planning for small businesses.
You’re likely a good candidate if you plan to hold the property for several years and want to reduce taxable income in the near term. This is particularly true if you’ve recently purchased, built, or completed renovations on the property.
On the other hand, if you plan to sell the property soon, the benefits may be limited. That’s because the IRS may require you to pay back a portion of the savings through depreciation recapture at the time of sale. This added tax liability can diminish the overall value of the strategy for short-term property holders.
How a cost segregation study works
While every cost segregation study is tailored to the property and business in question, the process typically follows a clear and structured path. Here’s what that process generally looks like and what you can expect along the way.
Step 1: Engaging a cost segregation specialist
The IRS expects technical precision, so working with a cost segregation specialist is best.
Typically an engineer, accountant, or tax expert with experience in property analysis and depreciation rules, these professionals offer cost segregation services that include:
- Site inspections.
- Review of construction documents and blueprints.
- Analysis of building systems and improvements.
- Detailed asset classification and cost estimation.
To get the most out of the study, businesses should prepare in advance by gathering key documents such as:
- Purchase agreements.
- Architectural plans.
- Renovation invoices.
- Prior depreciation records.
This groundwork enables the specialist to complete a more accurate assessment, improve audit readiness, and help you identify meaningful tax-saving opportunities.
Step 2: Identifying and categorizing assets
This phase involves a detailed cost segregation analysis of your property. Each asset is examined to determine its role, expected lifespan, and suitability for accelerated depreciation.
The process typically classifies components based on the following:
- Function (personal property vs. structural building elements).
- Useful life (5, 7, 15, or 39 years).
- Eligibility for accelerated depreciation deductions under IRS guidelines.
Qualifying items often include specialized electrical work, decorative fixtures, removable flooring, built-in millwork, and exterior improvements like parking lots or signage. The more thorough and precise the analysis, the greater the opportunity to reclassify assets to reduce your tax burden early in the property’s lifecycle.
Step 3: Reclassifying assets for faster depreciation
Once categorized, these assets are reclassified for faster write-offs.
You’ll then:
- Adjust your current year’s tax filings.
- Reduce your tax liability.
- Possibly amend past returns using IRS Form 3115 to capture missed deductions.
Accelerating depreciation shifts more expense to earlier years of ownership, resulting in larger upfront deductions and improved short-term liquidity. If done correctly, this step can free up capital for reinvestment and strengthen your financial position without waiting decades to realize the benefits.
Step 4: Applying bonus depreciation (if applicable)
Under current tax law, you may be eligible for bonus depreciation—the ability to fully deduct the cost of eligible property in the year it was placed in service if that occurred before 2023. This provision applies to assets with a recovery period of 20 years or less, including many components identified during a cost segregation study.
The bonus percentage is phasing down gradually each year and will expire after 2026 unless Congress extends it. Consult a tax advisor to determine how much bonus depreciation is still available and how it fits into your broader tax planning strategy.
Timing matters, so don’t wait too long to evaluate your options.
Benefits of a cost segregation study
A quality cost segregation study can help your business free up capital, reduce tax liability, and improve long-term financial performance.
- Improved cash flow: Reclassifying assets for shorter depreciation timelines allows businesses to claim deductions earlier, reducing taxable income in the early years of ownership. This creates liquidity that can be used to reinvest in operations, equipment, or hiring.
- Lower tax bills: Assets depreciated over 5, 7, or 15 years result in significantly larger upfront write-offs than the traditional 39-year schedule.
- Stronger real estate returns: By optimizing tax savings, cost segregation improves the after-tax return on commercial property investments, helping property owners maximize profitability.
- Retroactive savings: If you haven’t conducted a cost segregation study yet, you can still take advantage of prior missed deductions. Using IRS Form 3115, you can adjust past returns to capture unclaimed depreciation without filing amended returns.
Consider a business that purchases a $1 million commercial building. After completing a cost segregation study, $200,000 in assets are identified as eligible for accelerated depreciation. This adjustment leads to a $50,000 reduction in tax liability in the first year alone—capital that can then be redirected toward operations, hiring, or expansion.
Key considerations and potential risks
The IRS recognizes cost segregation as a legitimate tax strategy, but it has several important considerations that business owners should understand before proceeding.
Here’s what to keep in mind:
- IRS audit risk: If assets are misclassified or the study lacks proper documentation, it may trigger an IRS audit. Avoiding aggressive estimates and working with a qualified provider helps minimize this risk. A well-prepared study should follow IRS guidelines and be defensible under scrutiny.
- Depreciation recapture: If you sell the property after claiming accelerated depreciation, the IRS may require you to repay a portion of those tax savings. This process, called depreciation recapture, can increase your taxable gain and reduce the overall financial benefit of the strategy—especially for short-term owners.
- Short ownership periods: Businesses planning to relocate or sell within a few years may not realize enough upfront tax savings to justify the cost of the study.
- Importance of compliance: To structure the study correctly and remain compliant, businesses should always work with a tax professional or accountant for small businesses experienced in cost segregation.
As with any planning strategy, cost segregation works best when aligned with your broader goals.
How to get started with a cost segregation study
If you’re considering a study, here’s how to prepare:
- Determine if your property qualifies: A strong candidate for cost segregation is typically a commercial or rental property valued at $200,000 or more. Eligibility also depends on how recently the property was acquired, built, or renovated—and how long you plan to keep it. The strategy works best for long-term owners aiming to optimize their tax position over time.
- Consult a tax professional or cost segregation expert: Working with a qualified accountant or engineering firm experienced in cost segregation is essential. These professionals will ensure proper asset classification and IRS compliance.
- Gather necessary documentation: Before the study begins, organize purchase agreements, construction costs, blueprints, renovation invoices, and previous depreciation schedules. Consider outsourcing accounting for small businesses to help manage and compile these records efficiently if needed.
- Understand how to apply tax adjustments: If you haven’t previously applied cost segregation, IRS Form 3115 allows you to claim unrecognized depreciation retroactively without filing amended returns.
- Set realistic expectations: Speak with a professional to review your numbers. A qualified advisor can evaluate your property, run projections, and assess whether the tax benefits are worth the investment. Having a current small business financial report will support this analysis.
Maximize your tax savings with Archer Lewis
A cost segregation study is a strategic tool that can help businesses with commercial properties improve cash flow, reduce tax liability, and maximize their real estate investments. However, to achieve meaningful results and avoid missteps, it’s essential to work with experienced professionals.
Explore your property’s full tax-saving potential with the experts at Archer Lewis.
Schedule a consultation today to see whether a cost segregation study aligns with your overall business goals.
