Let's jump right into it. Cost segregation studies are powerful tools for maximizing depreciation deductions and minimizing taxes for commercial property owners.
What is a Cost Segregation Study?
A cost segregation study involves separating the costs of a property into different categories and assigning shorter depreciation schedules to them. The IRS allows commercial and residential properties to be depreciated typically over 27.5 to 39 years. However, items such as personal property, land improvements, and some building elements can be depreciated over 5, 7, or even 15 years.
A residential, warehouse, or any other property, is never just the structure. It also includes plumbing fixtures, carpets, sidewalks, fencing, and more.
If you were to purchase these assets themselves, you could depreciate them over five, seven, or 15 years. But they're usually purchased as part of a building acquisition or development and written off over the same useful life as the rest of the building: 27.5 years or 39 years.
Why Should Real Estate Investors Consider a Cost Segregation Study?
The primary reason for real estate investors to conduct a cost segregation study is the potential for tax savings. Some of the benefits include:
Increased Cash Flow: Accelerated depreciation reduces taxable income, leading to higher cash flow for reinvestment or personal use.
Improved Return on Investment (ROI): More cash flow can result in a better ROI. For instance, if cash flow increases by 20%, this can make a property more appealing to future investors.
Tax Deferral: Lowering taxable income in the initial years helps defer tax payments, leading to more capital available for growth opportunities.
Leverage Additional Deductions: In addition to depreciation, investors can also benefit from deductions related to repairs, maintenance, and improvements tied to the components identified in a cost segregation study.
This is best illustrated through an example. Consider a $400,000 residential property. If $100,000 is attributed to the land, the remaining $3000,000 is depreciated about $10,909 every year.
At a 24% marginal tax rate, this puts $2,618 back in your pocket. Okay. But what if you could depreciate in big chunks. How about a $60,000 depreciation expense in the first year? Now you're talking an extra $14,400 in your pocket in the first year. Very nice.
How Does a Cost Segregation Study Work?
Cost segregation studies require an in-depth analysis carried out by qualified professionals. Here’s how it typically unfolds:
Property Inspection: A certified cost segregation engineer visits the site to assess the property and identify components eligible for segregation.
Cost Analysis: The engineer evaluates construction costs, appraisals, and other key financial data to classify components accurately.
Documentation: A detailed report is produced, summarizing the findings. This report will include a breakdown of property value by category and suggested depreciation timelines.
Tax Filing: The owner utilizes the findings to enhance their tax filings, claiming accelerated depreciation for the identified components.
Unlocking Tax Benefits
Cost segregation studies serve as an effective tool for real estate investors aiming to improve tax efficiency and increase cash flow.
Cost segs combined with bonus depreciation and in some cases, Section 179 can help you deduct larger amounts of depreciation expenses in one year.
Although the process may seem daunting, working with experienced professionals can simplify it greatly and ensure proper implementation.
Buyer beware: There are problems to navigate through. You should always consider the following:
Short term rental loophole
Real Estate Professional Designation, or
Net rental income (profit) that can be reduced
If you think you would benefit from a cost segregation study, talk to your tax advisor. If they don't know, talk to me!
Comments