Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Cost Segregation Studies
Transcript
- Lucas: Luna, I was looking at a portfolio analysis this morning for a family office that owns about a dozen multifamily properties across the Sun Belt. Their tax team flagged something that's been on my radar for a while: cost segregation studies. Luna: Okay, I've heard the term but I'm not sure I could explain it to a client. Is it basically reclassifying assets for faster depreciation? Lucas: Exactly right. When you buy a commercial building, the IRS lets you depreciate the structure over 39 years. But not everything in a building is the structure itself. Personal property — think carpeting, cabinetry, specialty lighting, even landscaping — can be depreciated over 5, 7, or 15 years. Luna: So a cost segregation study is basically an engineering review that breaks out those shorter-life assets from the building shell? Lucas: That's the core of it. An engineering firm comes in, reviews the blueprints, sometimes does a site visit, and allocates the purchase price into different asset classes. For a $10 million apartment complex, you might reclassify 20 to 30 percent of the value into 5- and 7-year property. Luna: Twenty to thirty percent — that's two to three million dollars moving from a 39-year schedule to 5 or 7 years. The tax deferral must be substantial. Lucas: It is. In the first year alone, instead of taking maybe $250,000 in straight-line depreciation, you could take $700,000 or more. If you're in the top federal bracket — 37 percent — that's roughly $260,000 in tax deferral in year one. And with bonus depreciation, which is still at 80 percent for 2026 under the Tax Cuts and Jobs Act phaseout, you can accelerate even more. Luna: So the bonus depreciation provision lets you take a big chunk of that 5- or 7-year property immediately? Lucas: Correct. Under current law, bonus depreciation is phasing down from 100 percent in 2022 to 80 percent this year, then 60 percent next year, and so on until it sunsets in 2027. So this year, you can deduct 80 percent of the cost of qualified property immediately. For our $10 million building with $2.5 million reclassified to 5-year property, you could take $2 million in bonus depreciation in year one. Luna: That's enormous. But I've heard the IRS has scrutinized cost segregation studies. Is there a risk of an audit? Lucas: The IRS did issue a directive in 2014 — Audit Techniques Guide for Cost Segregation — so they're certainly aware of the strategy. But if the study is done by a qualified engineering firm with proper documentation, it's perfectly legitimate. The key is that it's not a tax gimmick; it's an engineering allocation. The IRS's own guide says the study should be based on a detailed cost estimate, not just a percentage approximation. Luna: So you don't want your accountant just guessing 'let's call 20 percent personal property' and slapping it on the return. Lucas: Exactly. That's a red flag. A proper study from a firm like KBKG or Capstan Tax Strategies will run $15,000 to $30,000 for a typical commercial property. But when you consider the first-year tax savings can be in the hundreds of thousands, the return on investment is often 10 to 1 or higher. Luna: And these studies aren't just for new construction, right? They can be done on existing properties that were acquired years ago? Lucas: Absolutely. You can perform a look-back study on a property you've owned for several years. The depreciation you missed in prior years can be captured as a Section 481 adjustment — essentially a catch-up deduction taken in the current year, with no amended returns needed. I've seen cases where a client bought a building in 2019, did a study in 2024, and got a $400,000 catch-up deduction. Luna: That's a nice surprise for the tax return. But what about when you sell? Depreciation recapture is a thing — does cost segregation make that worse? Lucas: It does accelerate the recapture, but it's still a timing game. The depreciation you take early is at ordinary income rates, and recapture at sale is also at ordinary rates — up to 25 percent for unrecaptured Section 1250 gain. But by deferring tax early, you keep more capital working for you. And many wealthy families pair cost segregation with a 1031 exchange to defer the recapture indefinitely. Luna: So the strategy is: buy a property, do the study, take big depreciation, then 1031 into a larger property, rinse and repeat. Lucas: Exactly. I know a family office in Denver that's done this across a portfolio of 20 self-storage facilities. They do a cost segregation study on each acquisition, take the bonus depreciation, then after five to seven years, they sell and 1031 into newer facilities. They've effectively deferred tax on tens of millions in gains for over a decade. Luna: And they're not doing anything aggressive — they're just following the tax code as written. Lucas: That's the beauty of it. It's not a loophole; it's a deliberate incentive Congress created to encourage investment in real estate. The same logic applies to tenant improvements — if you renovate a building, the new carpet, lighting, and millwork can also be segregated. Luna: But there must be some properties where cost segregation doesn't make sense. Like, if you're buying a single-tenant net-lease property with a long-term tenant, maybe the upfront cost isn't worth it? Lucas: That's a fair consideration. For a small property under $1 million, the study cost might eat too much of the benefit. Also, if you're a passive investor in a fund, the fund manager typically does the study at the entity level — you can't do your own. But for high-net-worth families directly owning multifamily, office, industrial, or even hospitality assets, it's almost always worth a look. Luna: So if I'm a listener with a $5 million office building I bought in 2021, what's my first step? Lucas: Call a cost segregation firm that specializes in engineering-based studies. They'll ask for your purchase agreement, closing statement, and any appraisals. They'll do a preliminary analysis for free, estimating how much can be reclassified and what the tax savings would be. Based on that, you decide if the full study is worth it. Luna: And if the numbers work, you could be looking at a six-figure deduction this year. Lucas: Easily. And let's not forget the state tax angle. Many states follow federal depreciation rules, but some — like California — don't conform to bonus depreciation. So you need to check state treatment. But overall, cost segregation is one of the most powerful yet underutilized tools in the high-net-worth tax playbook. Luna: I'm sold. I'm actually going to look into this for a property I co-own. Any final caution? Lucas: Just one: don't wait. With bonus depreciation phasing down, every year you delay means a lower percentage. If you bought a property in 2025, you'd get 80 percent bonus in 2026. Wait until 2027, and it drops to 60 percent. The window is narrowing. Luna: Great point. And speaking of windows — if our money conversations have helped you think about a decision differently, we'd be grateful if you considered supporting the show. It's listener-supported and ad-free, and it keeps us going. Lucas: Yeah, if you've gotten value from episodes like this one, you can buy us a coffee at buy me a coffee dot com slash fexingo. Every bit helps keep the podcast independent. Luna: That's buy me a coffee dot com slash fexingo. Now back to the tax playbook — what about combining cost segregation with a qualified opportunity zone investment? Lucas: That's a great next-layer question. Opportunity zone funds already offer deferral on capital gains, plus potential exclusion on appreciation if held long enough. Add cost segregation on the underlying property, and you've got a triple tax benefit. I've seen funds structure it so investors get bonus depreciation passed through on their K-1s, on top of the OZ deferral. Luna: So the depreciation flows through to the limited partners, and they can use it against other passive income? Lucas: Yes, assuming they meet the material participation rules or have other passive activities. It's complex, but for a sophisticated investor, the combination can dramatically reduce current tax liability. I'd say cost segregation is table stakes for any serious real estate investor today. Luna: But it's not just for big commercial deals, right? What about a high-end residential rental — say a $3 million duplex in Miami? Lucas: It works there too. Residential rental property is depreciated over 27.5 years, not 39, so the benefit is slightly smaller, but still significant. On a $3 million duplex, you might reclassify 15 to 20 percent into shorter-life assets. With bonus depreciation, that could mean a $300,000 to $400,000 deduction in year one. Luna: And that deduction could offset rental income from other properties, creating a net operating loss that shelters W-2 income if you're a real estate professional. Lucas: Bingo. Real estate professionals — defined as spending over 750 hours per year in the business — can use passive losses against ordinary income. For a high-earning doctor or lawyer who qualifies, cost segregation can turn a rental property into a massive tax shelter. Luna: So the key is not just having the property, but having the professional status to use the losses. Lucas: Exactly. And that's where wealth planning gets interesting. Many ultra-wealthy families will structure their ownership so one spouse qualifies as a real estate professional, aggregating all their activities to meet the threshold. Then the cost segregation losses become fully usable. Luna: That's a level of planning most people don't think about. Lucas: It's the difference between owning real estate and optimizing real estate. Let me give you a concrete example from my files. A family in Chicago bought a 50-unit apartment building for $12 million in 2024. They did a cost segregation study that reclassified $2.8 million into 5-year property. With 80 percent bonus, they took a $2.24 million deduction in year one. Combined with the building's regular depreciation, their first-year deduction was over $2.6 million. Luna: On a $12 million asset, that's a 22 percent first-year write-off. Their effective tax rate on that property must have been negative. Lucas: It was. They had net operating losses that sheltered income from other ventures. And because they 1031-exchanged out of their previous property, they had no recapture to worry about. It was a clean deferral chain. Luna: So the playbook is: buy, segregate, depreciate, exchange, repeat. And with bonus depreciation fading, the time to act is now. Lucas: Exactly. And the beauty is, it's not a new invention. Cost segregation has been around since the 1960s, but it's become more popular as wealthy families realize the magnitude of the benefit. I think in five years, it will be standard practice for any acquisition over $2 million. Luna: I'd bet you're right. Thanks Lucas — I'm definitely going to make some calls. Lucas: Happy to help. And for our listeners, if you own commercial or residential rental real estate, a cost segregation study might be the best ROI you'll get this year.