Tax Day = Savings

Have you ever wondered how some investors seem to pay less in taxes? If you have, you're not alone. The truth is, anyone can benefit from our tax system if they understand the basic rules of the game. Luckily, one tax "secret" that real estate investors use to minimize their tax liability on rental income is not hard to find - it's called cost segregation.

What is Cost Segregation?

Cost segregation is a tax strategy that allows real estate owners to accelerate the depreciation of their real estate by classifying certain parts of the building as personal property, meaning 100% of that asset can be depreciated in the first year. This strategy can increase cash flow and reduce federal and state income taxes on their rental income. Without a cost segregation study, real estate is typically categorized into two categories: land and building. Land is not depreciable, while the building is depreciated over 27.5 years (for residential properties) or 39 years (for commercial properties). While depreciation is beneficial, it does little to offset taxes without a cost seg.

Is Cost Segregation Worth It?

The value of cost segregation depends on your unique situation, which is why it's important to involve an expert. Thanks to the 2017 Tax Cuts and Jobs Act, used property is now eligible for 100% bonus depreciation, which can be taken on assets with tax lives of 20 years or less. This means that assets in the personal property and land improvements categories can be written off in the first year. However, it's important to note that the bonus depreciation rate will be phased out in the coming years, starting at 80% in 2023 and reducing to 0% in 2027 and later years. Nevertheless, even without bonus depreciation, there are still benefits to cost segregation due to the shorter depreciation periods of 5, 7, and 15 years for building components, compared to the standard 27.5 or 39 years for buildings.

Example of Cost Segregation

Let's look at an example to illustrate the potential benefits of cost segregation. Suppose you purchase a commercial warehouse for $5,000,000, ignoring the land portion. Without a cost segregation study, this property would be depreciated over 39 years, resulting in roughly $128,000 in depreciation expense per year. However, if a cost segregation study is performed, $1,000,000 can be considered as personal property, and $500,000 can be considered as land improvements, based on the current law concerning bonus depreciation. This means that $1,500,000 can be written off in the first year. The remaining $3,500,000 is depreciated over 39 years.

Assuming a 40% tax rate, this strategy would yield a federal income tax savings of $600,000 (1,500,000 x 0.40). Even if the full $1.5M cannot be utilized in the first year, the unused benefit/loss can be carried forward to offset future rental profits. The cash savings from the tax deduction can provide the property owner with the ability to invest in another sizable project by using the savings as a down payment.

Long-Term Benefits of Cost Segregation

The benefits of cost segregation extend beyond just the immediate tax savings. By accelerating depreciation deductions and reducing tax liability, property owners can significantly increase their cash flow, which can be used for other investments or business expansion. The additional cash on hand can also be used to fund renovations, upgrades, or other improvements to the property, thereby enhancing its value and potentially increasing rental income.

Furthermore, the ability to defer taxes through cost segregation can provide property owners with more flexibility in managing their overall tax burden. By reducing current tax liability, property owners can potentially invest in other income-producing assets or take advantage of other tax planning strategies.

Cost segregation studies also offer the advantage of providing a detailed breakdown of the property's components and their respective tax lives. This information can be beneficial for property owners in the future, as it can help them accurately track depreciation expenses and make informed decisions about property management, refinancing, or selling. Additionally, if the property is sold, the cost basis for each component can be used to determine the capital gains tax, potentially resulting in further tax savings.

In conclusion, a cost segregation study requires technical expertise and compliance with IRS regulations, so it's crucial to engage professionals with experience in this area. With the proper implementation of cost segregation, you can optimize your tax savings, increase your cash flow, and ultimately enhance your overall financial position in the real estate market