Real estate investors are paying thousands for 'cost segregation studies,' a tax strategy to increase cash flow. Here's how they work and who can benefit.

• A 'cost seg study' can help investors accelerate depreciation deductions and, ultimately, boost cash flow.
• It involves having an engineer analyze the property's internal and external elements.
• They cost a few thousand dollars and don't make sense for everyone, but could save certain investors big money.

Owning rental property comes with significant tax advantages. So significant that, when used strategically, they can help investors scale solely through tax savings.

Jill Green, a full-time physician who invests in real estate with her husband on the side, has used tax savings to grow her portfolio by roughly one property per year.

One of the strategies behind her growth: cost segregation studies, which allow her and other real estate investors to accelerate depreciation.

Why depreciation matters

Rental property owners can deduct a wide range of expenses, including mortgage interest and insurance, as well as travel and equipment costs, thereby significantly reducing their taxable income.

One of the most powerful deductions is depreciation.

Depreciation allows investors to deduct the cost of a building over its IRS-defined useful life: 27.5 years for residential properties and 39 years for commercial properties. To calculate annual depreciation, owners divide the building's value (excluding land) by the applicable timeline.

For example, if you buy a $1 million commercial building, standard depreciation allows you to deduct 1/39 of its value each year.

A cost segregation study changes that math.

How a 'cost seg' works

A cost segregation study, often called a "cost seg," accelerates depreciation by separating a building into components that can be depreciated more quickly than the building as a whole.

Engineers analyze the property's internal and external elements — such as flooring, electrical systems, plumbing, and HVAC — and reclassify certain portions into shorter depreciation categories of five, seven, or 15 years. They may determine that an electrical outlet is not expected to last 39 years, for example, and, instead, is a three-year asset.

So, instead of depreciating the entire $1 million building over 39 years, portions of it may qualify for faster write-offs. That acceleration can dramatically increase first-year deductions.

Using the same $1 million example: rather than deducting about $25,600 in year one (1/39 of $1 million), an investor could potentially deduct hundreds of thousands of dollars upfront through accelerated and bonus depreciation.

Claiming larger deductions early in ownership reduces tax liability and increases available cash.

"You can take a big chunk in those first couple of years and basically put yourself into a loss position because the deduction is so large," CPA Kristel Espinosa told Business Insider. "If you don't need all of the loss in the current year, that loss carries over into subsequent years, so those losses could shelter the rental income from this property for years to come."

Note that, in most cases, depreciation can offset passive income — such as rental income — but not active income like W-2 wages. However, investors who qualify as real estate professionals under IRS rules can use rental losses to offset active income. Green's spouse qualifies for real estate professional status, or REPS, which makes their cost segregation studies especially powerful: the accelerated depreciation deductions can offset active income, delivering significant and immediate tax savings that wouldn't otherwise be available.

Who cost segregation makes sense for

A cost seg study typically costs several thousand dollars and can take one to two months to complete. Whether it makes sense depends on the property's size, purchase price, and the investor's tax situation.

Espinosa said the strategy often works best for higher-income investors who own commercial properties or large portfolios.

As a general rule, "a cost segregation study typically allows 20% to 40% of a building's cost to be reclassified into shorter depreciation periods," she said. "This can generate first-year tax savings of $50,000 to $150,000+ per $1 million in building cost, depending on the study results and your tax situation."

She gave the example of a $15 million commercial building. If $5 million is reclassified into shorter-life assets and qualifies for bonus depreciation, that could generate $3 million in deductions. At a 37% federal tax rate, that's roughly $1.11 million in federal tax savings, before accounting for state taxes.

In one case, Espinosa said a client saved about $1.8 million in taxes after paying roughly $10,000 for the study. That wasn't an extreme case for her client base, which includes high-income earners in top tax brackets who typically own large portfolios and commercial buildings, she said.

Still, cost seg studies don't make sense for every property. They're generally more valuable for commercial buildings, which have more components to reclassify, and for higher purchase prices.

Green said she consults her CPA before ordering a study. When she bought a $123,000 property, it didn't make financial sense, especially since she planned to sell it quickly.

Espinosa advises investors to work closely with experienced CPAs and cost segregation specialists and to retain detailed engineering reports in case of an audit.

"Cost segregation is powerful," she said, "but it requires careful execution."