The A-to-Z Glossary of Cost Segregation
If you own commercial real estate or a residential rental property, you might have heard about one of the most powerful tax deferral strategies available: the cost segregation study. But the jargon can be overwhelming. What exactly is MACRS? How does §1245 property differ from §1250? What’s the “time value of money” got to do with it? This glossary breaks down the essential concepts you need to understand to harness the power of cost segregation and transform your tax strategy along with your CPA, or your tax strategy team.
A
Accelerated Depreciation
Depreciation methods that allow for larger deductions in the early years of an asset's life. Cost segregation enables this by reclassifying assets to shorter recovery periods.
Audit Techniques Guide (ATG)
A detailed guide published by the IRS that examiners use during audits. A credible cost segregation study will align with the principles and methodologies outlined in the IRS’s Cost Segregation ATG to ensure defensibility.
B
Bonus Depreciation
A tax incentive that allows a business to immediately deduct a significant percentage (phasing down from 100% as of 2023) of the cost of eligible property in the year it is placed in service. Cost segregation identifies qualified property (often 5, 7, and 15-year assets) that can trigger this powerful deduction.
Building vs. Structural Component
A core distinction in a study. The building is the overall structure (39-year property). A structural component (e.g., roof, HVAC, plumbing) is integral to the building and is also depreciated over 39 years. The goal is to identify items that are non-structural or serve a specialized business function, allowing for shorter depreciation.
C
Cost Segregation Study
An engineering-based analysis conducted by qualified specialists. It deconstructs a property’s purchase or construction costs, identifying and valuing individual components for proper tax classification. This is the formal report that substantiates your accelerated depreciation claims to the IRS, and this is what USTAGI is here to do.
D
Depreciation
The tax concept that allows you to deduct the cost of a tangible business asset over its "useful life," as defined by the IRS. It’s a non-cash expense that reduces taxable income.
Deferred Tax Liability
A bookkeeping entry that arises when you accelerate tax deductions. It represents taxes you will owe in the future (upon sale due to recapture) but are not paying today. This is a strategic benefit, an interest-free loan from the government that boosts your current cash flow.
E
Engineering Approach
The most detailed and defensible method for conducting a cost segregation study. It involves a detailed analysis of construction blueprints, site inspections, and cost data to accurately assign costs to specific asset classes.
F
§1245 Property
A tax code classification that includes most tangible personal property (e.g., equipment, furniture, specialized wiring) and certain land improvements. Gains from the sale of §1245 property, to the extent of depreciation taken, are recaptured at ordinary income tax rates (currently up to 37%).
§1250 Property
A tax code classification that primarily includes real property (the building and its structural components). Upon sale, depreciation recapture for §1250 property is generally taxed at a maximum rate of 25%.
I
Internal Rate of Return (IRR)
A financial metric used to evaluate the profitability of an investment. In cost segregation, a high IRR on the study’s cost indicates that the upfront fee yields a very strong return via accelerated tax savings.
L
Land Improvements
Assets that are affixed to the land but are not the building itself, such as parking lots, sidewalks, landscaping, and fencing. These are classified as 15-year property under MACRS and are often eligible for bonus depreciation.
Look-Back Study
A cost segregation study performed on a property that was placed in service in a previous tax year. This allows owners to "catch up" on missed depreciation deductions in a single year without amending past returns, via a §481(a) adjustment.
M
MACRS (Modified Accelerated Cost Recovery System)
The current IRS system for depreciating most tangible business property. It mandates specific recovery periods (e.g., 5, 7, 15, 27.5, 39 years) and depreciation methods. Cost segregation ensures assets are assigned to the correct, shortest possible MACRS class.
N
Net Present Value (NPV)
A calculation of the current value of a stream of future tax savings. By accelerating deductions, cost segregation increases the NPV of your depreciation benefits, putting more cash in your pocket today.
P
Personal Property (Tangible Personal Property)
Assets that are tangible, movable, and not permanently affixed to real estate. Examples include office furniture, machinery, and removable specialized equipment. These are typically 5 or 7-year property.
Placed-in-Service Date
The critical date when a property (or asset) is ready and available for its specific use. This date triggers the start of depreciation and determines the tax year for taking deductions and bonus depreciation.
R
Real Property
Land and anything permanently attached to it (e.g., buildings, fixed structures). For depreciation, this is generally split between non-depreciable land and the building, which is depreciated over 27.5 years (residential) or 39 years (commercial).
Recapture
The potential tax consequence upon the sale of a property where accelerated depreciation is taken. The portion of the gain equal to the depreciation deducted is "recaptured" and taxed as ordinary income (§1245 property) or at a 25% rate (§1250 property). This is a key factor to model when evaluating the study's benefit.
Residual Approach
A cost segregation methodology that estimates the value of the basic building shell and allocates the remaining cost (the "residual") to shorter-life personal property and land improvements. Often used when detailed records are unavailable.
S
Section 179 Expensing
A tax code provision that allows businesses to immediately deduct (expense) the full cost of qualifying property, up to an annual limit, in the year it is placed in service. Cost segregation can identify additional assets that may qualify for this expensing.
T
Tax Basis
Generally, your investment in the property for tax purposes: purchase price plus capital improvements, minus land value. Cost segregation allocates this depreciable basis into the correct asset categories.
Time Value of Money (TVM)
The foundational financial principle that money available today is worth more than the identical sum in the future due to its potential earning capacity. This is the core benefit of cost segregation: accelerating deductions delivers tax savings now, which can be reinvested in your business.
U
Useful Life
The estimated number of years an asset is expected to be usable. The IRS defines this via MACRS recovery periods. Cost segregation’s goal is to assign each component its true, shorter useful life for tax purposes.
Zen Zone: Putting It All Together
A cost segregation study is the process of reclassifying components of a real estate investment from long-life (39-year) real property to shorter-life (5, 7, 15-year) personal property and land improvements. This strategic reclassification, under MACRS, allows for accelerated depreciation, the maximization of bonus depreciation, and a significant improvement in near-term cash flow thanks to the time value of money.
Who Should Consider It? Owners of:
Newly constructed or purchased commercial buildings
Manufacturing facilities
Apartment buildings
Hotels
Major leasehold improvements
While the concepts involve tax law, engineering, and finance, the outcome is simple: pay less tax today and keep more cash in your business. Consulting with a qualified tax advisor and a reputable cost segregation firm is essential to ensure a compliant, defensible, and maximized study.
Disclaimer: This glossary is for informational purposes only and does not constitute tax advice. Please consult with a qualified tax professional or CPA regarding your specific situation.