In the competitive hospitality sector, achieving financial efficiency and effective tax planning is vital. Hotel ownership presents unique opportunities to enhance cash flow and minimize tax obligations, particularly through the implementation of cost segregation. This article delves into the nuances of cost segregation, their significant advantages for the hospitality and lodging industry and how they can be utilized to optimize financial outcomes.
An overview of cost segregation studies
Cost segregation is a strategic tax saving procedure that employs engineering-based analysis to identify, segregate and reclassify various assets of a property —including but not limited to parking lots, guest rooms, fitness centers, kitchens and offices. By identifying these assets that can be depreciated at an accelerated rate, property owners can enhance their cash flow and reduce tax burdens. This is especially beneficial for properties that have been constructed, purchased, expanded, remodeled or even that have previously been placed-in-service.
The process of conducting a cost segregation study
Cost segregation studies are typically carried out by professionals with expertise in fields such as construction, appraisal, architecture, engineering and/or taxes, and adhere to the IRS cost segregation guidelines. The ideal timing for these studies is during or after property acquisition or construction. However, owners can also conduct "look-back" studies on properties that were put into service up to 20 to 25 years ago, without the need to amend tax returns, thus offering flexibility in reaping financial benefits.
A cost segregation study involves multiple steps, such as gathering the necessary information about the property, including details about its type, amenities, acquisition and construction plans. After collecting this data, a site inspection is conducted to photograph and document the property. The team conducts a thorough review of the construction blueprints and a detailed engineering analysis and estimate of the costs based on the information provided, to identify, segregate, and reclassify these assets into different tax categories, including 5-year, 7-year, and 15-year classifications.
Understanding Qualified Improvement Property (QIP) and bonus depreciation
Qualified Improvement Property (QIP) relates to improvements made to a building's interior, excluding structural components or external elements. Examples include updated bathroom fixtures, new lighting installations and enhanced interior finishes, which are classified under a 15-year tax life, making them eligible for accelerated depreciation.
Bonus depreciation enables businesses to immediately deduct a significant portion of the cost associated with qualifying assets, rather than spreading the expense across the asset’s useful life. The bonus depreciation rate fluctuated over recent years, with 100% available from the end of 2017 through 2022, dropping to 80% in 2023, 60% in 2024, and 40% in 2025, with further reductions expected unless legislative changes occur. Staying informed about these changes is essential for maximizing tax benefits.
Assets that qualify for bonus depreciation include:
- Furniture and fixtures
- Kitchen, restaurant and hotel equipment
- Land improvements
- Interior enhancements
- Specialized HVAC, plumbing and electrical systems
The relationship between interest limits and bonus depreciation
Bonus depreciation and business interest deductions are interconnected, influencing how hotel owners can optimize their tax strategies. While hotel owners can still benefit from bonus depreciation even with interest expenses, they must ensure their total interest expenses remain below certain thresholds to maximize deductions. Regularly evaluating interest expenses and adjusted taxable income is a smart tax planning approach
Compelling case studies
A hotel owner constructed a new property for $20 million. Through a cost segregation study, $6 million of assets were identified for shorter depreciation periods, leading to more than $3.8 million in first-year depreciation deductions and over $1.2 million in tax savings, significantly boosting cash flow and profitability.
Another hotel owner, who had never performed a cost segregation study on a $25 million property purchased in 2021, conducted a look-back study and reclaimed missed deductions from past tax years. By identifying over $7.5 million in misclassified assets, the owner realized over $7.5 million in depreciation deductions and more than $2.4 million in tax savings in 2024.
A hotel owner who remodeled their property for $7.5 million identified $2.2 million in assets eligible for shorter depreciation lives, achieving over $1.5 million in first-year deductions and $460,000 in tax savings. Additionally, the owner was able to write off the remaining basis of demolished assets in the same year, further enhancing cash flow.
Additional tax benefits for the hospitality industry
Beyond cost segregation, hotel owners can benefit from other services like Section 179D energy efficiency deduction studies. This key tax incentive allows the immediate deduction of the full cost of qualifying new and used equipment and other assets in the year of purchase, rather than through depreciation. The maximum deduction for 2025 stands at $1.25 million, with a phase-out limit of $3.13 million, potentially leading to significant tax savings.
In summary, cost segregation provides a powerful tool for hospitality businesses to improve cash flow and lower tax liabilities. By understanding the procedures, timelines, and related services, property owners can unlock substantial financial benefits. As tax regulations continue to evolve, staying proactive and well-informed is essential for exploiting these opportunities.
Lena Combs is a partner and hospitality practice leader at Withum, a technology-driven advisory and accounting firm. The company specializes in cybersecurity, digital advisory and hospitality services. Martin Harski is a principal and cost segregation team leader at Withum.
This column is part of ISHC Global Insights, a partnership between CoStar News and the International Society of Hospitality Consultants.
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