Does Cost Segregation Work for Properties With Mortgages?

Cost segregation mortgage questions often arise because owners assume debt affects depreciation eligibility or calculations. In fact, the presence of a mortgage does not change cost segregation mechanics. Depreciation is a tax concept based on basis, not a financing concept based on equity.

When you purchase property with a mortgage, your basis typically includes the full purchase price, which is the sum of cash down payment and borrowed funds. This basis is what you depreciate, regardless of how much of it was financed.

Cost segregation applies to the depreciable portion of that basis. The mortgage balance, interest rate, and loan terms do not affect the depreciation calculation. They affect cash flow and investment returns, but not the tax treatment of the building components.

Financing does not reduce depreciable basis. If you buy a property for one million dollars with a 200 thousand dollar down payment and an 800 thousand dollar mortgage, your basis is one million dollars. The depreciable portion, after allocating to land, is what you use for cost segregation.

This principle applies to all types of financing, including conventional mortgages, commercial loans, seller financing, and private debt. As long as the debt is legitimate and you are the owner, the full purchase price contributes to your basis.

Some owners mistakenly believe they can only depreciate the equity portion. That is incorrect. You depreciate based on basis, not equity. This is why leveraged property cost seg can produce significant deductions even with high loan to value ratios.

To illustrate how cost seg financed property works, consider a multifamily building purchased for two million dollars with 25 percent down and a 75 percent mortgage. The buyer's basis is two million dollars, and after allocating land, assume 1.6 million is depreciable.

A cost segregation study might identify 400 thousand dollars of components eligible for shorter lives. The depreciation deductions are calculated on that 400 thousand, not on the 500 thousand dollar down payment. The mortgage does not reduce the benefit.

In another example, an investor acquires an industrial property with a 90 percent loan to value ratio. The high leverage does not prevent cost segregation. The study analyzes the full depreciable basis, and the owner receives deductions based on the building components identified, regardless of equity percentage.

Cost segregation with loan can improve after tax cash flow more dramatically than with all cash purchases because the owner has less capital tied up. The tax savings from accelerated depreciation can offset debt service or be redeployed into reserves or new investments.

For leveraged investors, the relationship between debt service, rental income, and tax deductions matters. Cost segregation increases deductions, which can reduce taxable income and improve cash on cash returns. This is especially valuable when the property operates at a small profit or break even before depreciation.

The interaction between financing and cost segregation does not change the tax rules, but it does change the investment math. Investors should model the cash flow impact including debt service, tax savings, and reinvestment opportunities.

Refinancing a property after completing a cost segregation study does not affect the depreciation schedules or the study itself. Refinancing is a financing event that changes debt terms but does not change your basis in the property.

If you refinance and pull cash out, that cash is not taxable income and does not affect depreciation. The basis remains what it was before the refinance. The cost segregation study continues to apply as originally implemented.

Some owners perform cost segregation before a refinance to demonstrate improved cash flow to lenders. The tax savings from cost segregation can improve debt service coverage ratios, which may support better loan terms. This is a strategic use of cost segregation in the financing process.

Leveraged property cost seg often produces attractive returns on invested capital because the owner benefits from depreciation on the full basis while having invested less cash. This leverage effect applies to the tax benefits as well as to the property returns.

Why leveraged investors often benefit more

• Lower cash invested means tax savings represent a higher percentage return on equity.
• Debt service can create tighter cash flow, making tax savings more valuable for liquidity.
• Accelerated deductions can offset rental income that would otherwise be fully taxable.
• Improved after tax cash flow can support debt paydown or additional acquisitions.

Leveraged investors should evaluate cost segregation based on the cash flow impact relative to the study cost, not just the absolute dollar savings. The return on invested capital framework can make cost segregation more attractive for leveraged properties.

Lenders do not typically restrict cost segregation because it is a tax strategy that does not affect property ownership, use, or value. Cost segregation does not require lender consent, and most loan documents do not address depreciation methods.

In rare cases, a lender might ask about significant changes in tax reporting or financial statements. If cost segregation materially changes reported income, discuss it with your lender if required by your loan agreement. In practice, this is uncommon.

Cost segregation can improve financial ratios by increasing depreciation, which may reduce taxable income. Some lenders focus on cash flow before depreciation, so the impact on loan covenants may be minimal. Review your loan documents and consult your CPA if you have concerns.

Debt structure and cost segregation planning can be coordinated but are independent decisions. The choice of loan terms, interest rate, and amortization does not change cost segregation eligibility or results.

Some investors time cost segregation studies around refinancing to show improved cash flow. Others perform the study at acquisition to maximize near term deductions. The timing depends on cash flow needs, tax planning, and investment strategy.

If you plan to refinance or restructure debt, discuss the timing with your CPA. Cost segregation can be implemented before or after the refinance without affecting the outcome, but the cash flow impact may influence your financing decisions.