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Cost Segregation Studies for Real Estate Funds

May 18, 2023

In the current climate of shifting economics, rising interest rates and longer-than-projected hold periods, real estate funds are turning to cost segregation studies. Cost segregations can provide huge tax benefits to individual investors, even if current deductions are suspended or if they reverse due to the sale of an asset. There are several scenarios in which cost segregations benefit investors. 

Tax Losses

Many benefits fall under the “tax loss” umbrella. These are just a few.

Sponsors often have anchor investors who are in many of their numerous funds for large commitments. If a sponsor has a series of funds that are generating taxable income, they could utilize cost segregation studies to specific properties that provide tax deductions which could offset the taxable income allocated to their anchor investors. This process would therefore provide losses that will possibly be deductible to the anchor investor across all of their funds. While this doesn’t directly increase internal rate of return (“IRR”) within the fund or increase incentive distributions to the GP, it shows the investors that the GP is aware of how taxes could impact their returns and that they are willing to work with them to minimize their personal tax burden. If you were an LP, would you rather invest with a GP who is conscious of your tax situation or one who is indifferent to it? 

As GPs launch additional funds, each new fund is typically larger in size, which presents opportunities to use your latest fund to create tax losses that offset the income to the anchor investors across all your funds. Here is an example:

Investor Fund Taxable Income
Joe Smith Fund 1 100,000
Joe Smith Fund 2 100,000
Joe Smith Fund 3 100,000
Joe Smith Fund 4 100,000
Joe Smith Fund 5 100,000
Joe Smith Fund 6 (1,000,000)

The $1,000,000 deduction from Fund 6 was generated via a cost segregation study, and would provide Joe Smith with $185,000 of federal tax savings, assuming a 37% tax rate and $500,000 of other income. This is free cash flow that the LP can use for other investments, further compounding the benefit of the cost segregation study.

In addition to the up-front tax savings from the deduction in Fund 6 created by performing the cost segregation, there is also an opportunity to arbitrage tax rates. Typically, depreciation deductions reduce income taxed at a 37% rate for federal tax purposes. For Qualified Improvement Property (“QIP”), if an asset is held for more than one year, the deduction would be recaptured at a 25% tax rate for federal tax purposes when the property is sold. Even if you break even on the property, you’ve created an arbitrage of up to 12% for your investors by generating an ordinary deduction, which reduces ordinary income taxed at a 37% rate that is later recaptured and taxed at 25%. For personal property, the cost seg would also generate tax deductions that could save you up to 37% in tax. When these assets are sold, the gain on sale of personal property is recaptured at ordinary rates, but the economic value of these assets typically depreciates very quickly. This means that a minimal amount of your sales proceeds should be allocated to these assets and a minimal amount of gain would be recaptured at ordinary rates (37%). 

The above rate arbitrage is true even if the losses from the cost segregation are suspended on your investors’ personal tax returns. When an activity is disposed of, suspended losses relating to that activity are no longer suspended and become deductible in the current year. That means that if you had $100,000 of losses from depreciation deductions that were suspended and a $100,000 capital gain from the disposition of the asset created by the depreciation deduction, you would recognize a tax savings from this situation, assuming you had at least $100,000 of other ordinary income on your tax return. See the below table for reference. 

Cost Seg Creates $100K in Depreciation
Item Amount  Character
Ordinary Income  100,000  Ordinary
Freed Up Suspended Loss ( 100,000 ) Ordinary
Capital Gain  100,000 Capital
Taxable Income  100,000   
Total Tax 25,000  
No Cost Seg
Item Amount  Character
Ordinary Income 100,000 Ordinary
Freed Up Suspended Loss   Ordinary
Capital Gain _______ Capital

Taxable Income

Total Tax 37,000  
  • Assumes ordinary income is taxed at 37% and capital gains are taxed at 25%.  
  • Tax benefit is realized if the $100,000 of depreciation deductions are suspended until the asset is sold.  

Phantom Income

Cost segs can also be a valuable tool when a fund has assets that generate phantom income. Phantom income is a scenario where taxable income generated by the Fund exceeds cash available to distribute to investors. If a fund has assets that generate phantom income, it could cost seg its real estate assets to accelerate the depreciation deductions it is entitled to and offset the phantom income that would be allocated to its investors. 


There is no one-size-fits-all answer when deciding whether to perform a cost segregation study. A cost segregation study is a powerful tool when used in the right circumstances. It can produce meaningful tax savings to LPs and create tax deductions that offset phantom income allocations. Fund GPs should work with their tax advisor to determine how a cost segregation study may enhance the returns that they provide to their investors. 

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Jeffrey Hess

Jeffrey Hess is a Tax Partner in the Real Estate Services Group.

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