Cost Segregation: Accelerating Depreciation on Renovations
Cost segregation is a tax strategy that allows property owners to break down a building’s renovation costs into components that can be depreciated over shorter periods—typically 5, 7, or 15 years—instead of the standard 27.5 years for residential or 39 years for commercial property. By reclassifying building elements like lighting, HVAC, flooring, and landscaping, owners can claim larger deductions in the early years, freeing up cash for further improvements or other investments.
Why 2025 Is a Key Year
With bonus depreciation phasing down to 40% in 2025, this year is especially important for property owners to act strategically. Cost segregation, combined with the remaining bonus depreciation, allows for significant upfront deductions before the benefit phases out further in subsequent years. This is particularly advantageous for those managing rental spaces or commercial properties, as it enables more capital to be reinvested into property improvements or portfolio expansion.
The New Rules for Capital Improvements
Recent tax reforms and IRS guidance have clarified how renovations, repairs, and capital improvements should be treated for tax purposes. The key distinction is between:
- Repairs and Maintenance: These are generally deductible in the year incurred.
- Capital Improvements: These must be capitalized and depreciated over the appropriate recovery period.
Qualified Improvement Property (QIP)
A major change in recent years is the treatment of Qualified Improvement Property (QIP). QIP refers to interior improvements made to nonresidential buildings after the building was first placed in service, excluding structural changes, expansions, or upgrades like elevators. QIP now has a 15-year recovery period and is eligible for bonus depreciation, making it especially valuable for landlords and commercial property owners.
Cost segregation studies help identify and categorize QIP assets, ensuring they are accurately valued and depreciated as quickly as possible. This is particularly useful for landlords providing tenant buildout allowances or undertaking significant interior renovations.
Partial Asset Disposition (PAD): Writing Off Old Components
When renovating, property owners often remove or replace old building components. The IRS allows for partial asset disposition (PAD), which means you can write off the remaining undepreciated value of assets that are retired during renovations. This can create a substantial deduction in the year of the renovation, further improving cash flow. Cost segregation is essential for quantifying and documenting these assets before they are disposed of.
Practical Example
Suppose an owner renovates a commercial office building valued at $1,000,000. Through cost segregation, $300,000 of the renovation is reclassified into shorter-life assets. Instead of spreading deductions over 39 years (about $6,410 per year), the owner can claim $51,000 in deductions in the first year alone—funds that can be reinvested into additional improvements or new acquisitions.
Similarly, a residential rental property valued at $800,000 might have $160,000 of renovation costs eligible for accelerated depreciation. Instead of $7,273 per year, the owner could claim $27,250 in the first year, boosting cash flow for property maintenance or marketing.
Planning Your Strategy for 2025 and Beyond
- Act in 2025: With bonus depreciation at 40%, there’s still a valuable opportunity for immediate deductions. Pairing cost segregation with bonus depreciation maximizes upfront tax benefits.
- Leverage QIP: Interior improvements to nonresidential buildings may qualify for 15-year depreciation and bonus depreciation, offering faster write-offs.
- Use PAD: Write off the undepreciated value of assets removed during renovations for an extra deduction.
- Consult Professionals: Engage experienced tax advisors and cost segregation specialists to ensure accurate classification, compliance, and optimal tax outcomes.
Conclusion
Cost segregation and the new rules for capital improvements provide a powerful framework for tax-efficient renovations in 2025. By accelerating depreciation on qualifying assets, leveraging bonus depreciation, and utilizing strategies like partial asset disposition, property owners can reduce taxable income, increase cash flow, and make the most of their renovation investments. With bonus depreciation phasing out, now is the time to act and capture these valuable tax benefits.