The Industry's Uncomfortable Truth
Every cost segregation provider — including us — markets "tax savings." We show numbers like "$70,000 in first-year deductions" and "25x ROI" and "accelerated depreciation."
These numbers are real. But they are incomplete.
Here is the full picture that the cost segregation industry does not emphasize enough: cost segregation does not eliminate taxes. It shifts when you pay them. The depreciation you accelerate into year one is depreciation you would have taken over 27.5 or 39 years anyway. And when you sell the property, the IRS recaptures that accelerated depreciation at rates up to 37%.
The actual value of cost segregation is not "savings." It is timing — the time value of having cash now instead of later.
That distinction sounds academic. It is not. Understanding it changes how you evaluate the strategy, how you plan exits, and whether cost segregation is worth it for your specific situation.
Author's note (Sam Young, EA): I run a cost segregation company. Writing "cost segregation does not save you money" is not great for marketing. But it is closer to the truth than "cost segregation saves you $70,000," and I would rather you understand the real mechanics than buy a study based on a misleading headline. The honest math still strongly favors cost segregation in most cases. But the math works because of timing, not magic.
What Actually Happens When You Do Cost Segregation
Without Cost Segregation (Straight-Line Depreciation)
You buy a $1M rental property with $800K depreciable basis. Under straight-line depreciation, you deduct $29,091/year for 27.5 years. Slow, steady, predictable.
Total depreciation: $800,000 Total tax saved (35% rate): $280,000 — spread over 27.5 years
With Cost Segregation (Accelerated Depreciation + 100% Bonus)
Cost segregation reclassifies 28% of the basis ($224,000) to shorter-lived assets. With 100% bonus depreciation, that $224,000 is deducted entirely in year one.
Year-1 deduction: $224,000 (reclassified) + $20,945 (remaining straight-line) = $244,945 Year-1 tax savings: ~$85,730
Over the full hold period, total depreciation is still $800,000. Total tax saved is still $280,000.
The same total. Different timing.
Why Timing Is Worth Tens of Thousands of Dollars
The entire value proposition of cost segregation rests on one economic principle: a dollar today is worth more than a dollar in 10 years.
When you receive $85,730 in tax savings in year one instead of $10,182/year spread over 27.5 years, you can invest that cash immediately. The compounding returns are the actual economic benefit.
| Strategy | Year-1 Tax Savings | Total Tax Savings (Lifetime) | Cash Value After 10 Years (7% return) |
|---|---|---|---|
| Straight-line only | $10,182 | $280,000 | $140,861* |
| Cost segregation + bonus | $85,730 | $280,000 | $236,480** |
| Difference | +$75,548 | $0 | +$95,619 |
*PV of 10 years of $10,182/year savings invested at 7%. **$85,730 invested at 7% for 10 years = ~$168,659, plus continuing straight-line savings on remaining basis.
The total tax saved is identical. The economic value is $95,619 higher because of when you received the cash.
The Recapture Problem Nobody Wants to Talk About
When you sell the property, depreciation recapture applies:
- Section 1250 recapture (real property, straight-line portion): taxed at up to 25%
- Section 1245 recapture (personal property — the stuff cost segregation reclassified): taxed as ordinary income at up to 37%
This is not a hidden catch. It is the mechanism that makes cost segregation a timing strategy, not a savings strategy.
The Math With Recapture
Assume you sell after 5 years:
| Item | Amount |
|---|---|
| Accelerated depreciation from cost seg (year 1) | $224,000 |
| Tax savings at 35% | $78,400 |
| Section 1245 recapture at sale (37% rate) | $82,880 |
| Gross "loss" on the acceleration | -$4,480 |
Wait — cost segregation resulted in a net loss?
No. Because you had $78,400 for five years. Invested at 7%:
| Item | Amount |
|---|---|
| $78,400 invested for 5 years at 7% | $109,977 |
| Minus recapture tax | -$82,880 |
| Net economic benefit | $27,097 |
That $27,097 is the real value of cost segregation on that $224,000 reclassification. Not $78,400. Not $224,000.
Twenty-seven thousand dollars. Still excellent ROI on a $1,500 study. But it is 65% less than the "Year-1 savings" number the industry leads with.
When Timing Does Not Work in Your Favor
The time value equation breaks down in specific situations:
Short Hold Periods
If you sell within 12–18 months, the investment return on your tax savings barely exceeds the recapture cost. The net benefit approaches zero or turns negative.
| Hold Period | Net Benefit of Timing (on $78,400 savings) |
|---|---|
| 6 months | ~$2,700 |
| 1 year | ~$5,500 |
| 2 years | ~$11,300 |
| 5 years | ~$27,100 |
| 10 years | ~$75,800 |
| 20 years | ~$224,800 |
At 7% annual return. Does not account for study fee.
The longer you hold, the more timing works for you. This is the real reason we tell investors: hold at least 3 years, ideally 5+.
Low Investment Returns
If you do not invest the tax savings — if it sits in a checking account — the time value benefit is near zero. Cost segregation only delivers significant ROI when the freed-up cash is deployed productively.
1031 Exchanges Change Everything
Here is where timing becomes genuinely powerful. If you 1031 exchange into another property instead of selling outright:
- All depreciation recapture is deferred indefinitely
- The accelerated deductions carry forward with no tax consequence
- You keep the full compounding benefit without paying recapture
A cost segregation + 1031 exchange strategy is the closest thing to genuine tax savings (not just timing) because you may never trigger the recapture event.
Step-Up at Death: The Ultimate Timing Play
Under IRC section 1014, heirs receive a stepped-up basis at death. All depreciation — including accelerated depreciation from cost segregation — is permanently eliminated. No recapture. Ever.
This means cost segregation + hold until death = genuine permanent tax savings. The timing benefit becomes a permanent benefit because the recapture event never occurs.
Why the Industry Leads With "Savings" Instead of "Timing"
Three reasons:
1. "Save $70,000" is a better headline than "Shift $70,000 forward for a net economic benefit of $27,000 over 5 years."
The cost segregation industry — including us — simplifies the message because the full truth is harder to sell. The simplified version is not wrong (you do save $70,000 in year one), but it is incomplete (you owe much of it back at sale unless you plan around it).
2. Most investors plan 1031 exchanges or long holds, where the math is overwhelmingly positive.
For the typical cost segregation customer — someone planning to hold for 5–10+ years or exchange into another property — the timing benefit is massive and the recapture concern is manageable. The industry's simplified messaging works for this audience.
3. The nuanced truth requires more investor education.
Explaining time value of money, recapture rates by IRC section, passive activity limitations, and exit planning is a 15-minute conversation. Saying "save $70,000" takes 5 seconds. Most sales processes optimize for speed.
The Honest Framework for Evaluating Cost Segregation
Given that cost segregation is fundamentally a timing strategy, here is how to evaluate it honestly:
Step 1: Calculate Your Year-1 Tax Savings
Use the free calculator or your CPA's estimate.
Step 2: Ask "Can I Actually Use These Deductions?"
If passive activity rules limit your ability to use the deductions, the timing benefit shrinks because your "year one" might become "year five" before the deductions are fully utilized.
Step 3: Estimate Your Recapture Tax at Sale
Assume the reclassified portion will be recaptured at 25%–37% when you sell. (Unless you 1031 exchange or hold until death.)
Step 4: Calculate the Net Timing Benefit
Year-1 savings invested for your hold period, minus recapture tax at sale. If this number exceeds the study cost by 5x+, cost segregation is worth it.
Step 5: Consider Your Exit Strategy
- 1031 exchange: Recapture deferred. Timing benefit maximized.
- Hold until death: Recapture eliminated. Timing becomes permanent savings.
- Outright sale (3+ years): Timing benefit positive but reduced by recapture.
- Outright sale (under 18 months): Timing benefit minimal. Likely not worth it.
The Bottom Line
Cost segregation is one of the most effective cash flow tools in real estate. But the value comes from timing, not magic.
Understanding this distinction makes you a better investor. It means you:
- Do not panic about recapture (it was always part of the plan)
- Plan your exit strategy before commissioning a study
- Invest the tax savings productively instead of letting them sit idle
- Evaluate cost segregation ROI honestly instead of using inflated headlines
- Combine cost segregation with 1031 exchanges for maximum benefit
The industry headline is "cost segregation saves you money." The truth is "cost segregation gives you money earlier, and what you do with that time determines whether it was worth it."
For most investors with adequate hold periods and productive reinvestment, it is absolutely worth it. But now you know why.
Frequently Asked Questions
Q: Does cost segregation actually save money or just defer taxes? A: Cost segregation primarily shifts the timing of depreciation deductions — you receive larger deductions in year one and smaller deductions in later years. Total depreciation over the property's life is the same. The economic value comes from the time value of money: cash saved today can be invested and compounded. In specific scenarios — 1031 exchanges (recapture deferred) or hold-until-death (recapture eliminated via step-up basis) — the timing benefit becomes a permanent tax reduction.
Q: What is depreciation recapture and how does it affect cost segregation? A: Depreciation recapture is a tax assessed when you sell a property that has been depreciated. For cost segregation, Section 1245 recapture taxes the reclassified personal property components at ordinary income rates (up to 37%), while Section 1250 recapture taxes the remaining real property at up to 25%. This recapture reduces the net benefit of cost segregation but does not eliminate it for holds of 3+ years due to time value of money. Recapture is deferred in 1031 exchanges and eliminated at death.
Q: Is cost segregation worth it if I plan to sell in 5 years? A: Generally yes. With a 5-year hold, the compounding returns on your accelerated tax savings typically exceed the recapture cost by a meaningful margin. Using our example: $78,400 saved in year one grows to ~$110,000 over 5 years at 7%, while recapture costs ~$83,000. Net benefit: ~$27,000 — an 18x return on a $1,500 study fee. Longer holds produce even better results.
Q: How do 1031 exchanges interact with cost segregation? A: Extremely well. A 1031 exchange defers all depreciation recapture — including the accelerated depreciation from cost segregation. This means you get the full year-one timing benefit without triggering recapture at sale. If you continue exchanging, recapture is deferred indefinitely. This is why sophisticated real estate investors combine cost segregation with 1031 exchange strategies for maximum tax efficiency.
Q: Why do cost segregation companies advertise "savings" if it is really just timing? A: Because "save $70,000 in taxes" is simpler and more compelling than "shift $70,000 forward in time for a net economic benefit of $27,000 over 5 years." The simplified version is not wrong — you do receive $70,000 less in taxes in year one — but it is incomplete because it omits recapture at sale. For investors who 1031 exchange or hold long-term, the simplified messaging is reasonably accurate. For short-hold investors, it is misleading.
Continue Reading
- Is Cost Segregation Worth It? — The complete decision framework with real scenarios
- Why Cost Segregation Is a Bad Idea (Sometimes) — The 7 situations where cost seg does not make sense
- Why Most Tax Strategies Fail at Exit — Exit planning most investors skip
- How Much Does Cost Segregation Save? — Real data from 1,000+ studies
- Affordable Cost Segregation Options — Engineering studies starting at $499
Disclaimer: This content is for informational purposes only and does not constitute tax, legal, or financial advice. The economic models described use simplified assumptions (7% investment return, 35% tax rate, 37% recapture rate) for illustration. Actual results depend on your specific tax situation, investment returns, hold period, and applicable law. Consult qualified tax and legal professionals regarding your individual circumstances.