Updated on September 8, 2023 by David Korpel
If you’re in the real estate investment game, you’ve probably heard of cost segregation. it’s a powerful strategy that can substantially lower your tax burden and boost your cash flow. Let’s delve into the mechanics to ensure we’re all on the same page.
When you invest in a real estate property, one of the tax advantages you gain is the ability to depreciate the asset over a set period—27.5 years for residential properties and 39 years for commercial ones. For instance, if you purchase a residential property valued at $200,000 (non-land portion), you’re entitled to an annual depreciation expense of $7,272 for the next 27.5 years. This is a non-cash expense, meaning you can claim it regardless of whether you own the property outright or are still paying off a mortgage.
Now, this is where cost segregation studies come into play. These specialized analyses allow you to break down the purchase price into its individual components, such as fixtures and specific systems like HVAC. In that $200,000 home, the cost segregation study reveals that the air conditioning and heating unit accounts for $13,000, and fixtures amount to $5,000. That totals $18,000, which can be “accelerated,” allowing you to recognize this expense in the year the study is conducted.
So, what does this mean for you? The book value of the home is now $182,000, leading to a revised annual depreciation of $6,618 over 27.5 years. But here’s the kicker: you also get to accelerate $18,000 of depreciation, giving you a whopping $24,618 in non-cash expenses for the first year alone. That’s over 10% of the asset’s initial cost, significantly enhancing your tax efficiency if you can deduct real estate rental losses (this is a BIG consideration in the cost seg decision).
Here’s a closer look at how it works and when it might fit your investment strategy.
Why Cost Segregation is Trending
The 2017 Tax Cuts & Jobs Act made cost segregation even more appealing by allowing 100% of bonus depreciation to be written off in the year it’s incurred. However, it’s important to note that these benefits are set to phase out starting in 2023. So, if you’re considering a cost segregation study, now is the time to act.
Is Cost Segregation Right for You?
Cost segregation studies can be costly, so it’s crucial to evaluate whether the potential tax benefits will outweigh the expense of the study itself. If you’re only saving $2,000 in taxes due to this study being done, but the study costs $5,000, you’re not saving any money.
The Basics of Cost Segregation
When you purchase a property, you’re not just buying the building but also its interior components like appliances and carpeting. Cost segregation allows you to accelerate the depreciation of these elements, leading to immediate tax savings.
Ideal Scenarios for Cost Segregation
- New Property Acquisitions: The most common reason to consider a cost segregation study is when you’ve recently purchased a property.
- Alternative to 1031 Exchanges: If you’ve sold a property and acquired another, a cost segregation study can offset the gains from the sale. This allows you to effectively offset a gain you might have from the first sale without following the complicated rules surrounding a 1031 exchange.
- During Renovations: If you’re making significant improvements to your property, cost segregation can help you write off components you’re replacing.
When to Think Twice
- Future Real Estate Professionals: If you plan to become a real estate professional, you might want to delay the study to maximize non-passive losses. Because once you accumulate passive losses, those losses are passive forever and can’t be converted. But if you wait to qualify as a real estate professional to do the study, you can recognize those losses immediately.
- Long-Term Owners: If you’ve owned the property for several years, the benefits of a retroactive study may be limited.
- Lower-Value Properties: For properties worth less than $500,000, the cost of a full study may not justify the potential tax benefits.
Cost segregation can offer substantial tax advantages for real estate investors, but it’s not a one-size-fits-all solution. Carefully consider your specific circumstances and consult with a tax professional to determine if it’s the right move for you.
The Bottom Line
Navigating the world of real estate investment can often feel like a maze, filled with complex terms and strategies that can make even the savviest investor’s head spin. That’s why tools like cost segregation are so invaluable. They offer a clear path to tangible benefits, like tax savings and improved cash flow, that can make a significant difference in your investment’s profitability.
Additional Insights
- Consult the Experts: While cost segregation can be a game-changer, consulting with tax professionals who specialize in this area is essential. They can provide personalized advice tailored to your specific situation.
- Stay Updated: Tax laws are ever-changing. Keeping abreast of the latest updates can help you make timely decisions and maximize your benefits.
- Long-Term Planning: Cost segregation is not just a quick fix; it’s a strategic move that can impact your long-term investment goals. Consider how it fits into your broader financial plan.
- Diversify: While cost segregation can offer significant tax advantages, it’s important to have a diversified investment strategy. Don’t put all your eggs in one basket; explore other avenues for tax savings and investment growth.
By taking the time to understand the nuances of cost segregation and how it fits into your overall investment strategy, you’re not just saving money—you’re investing in your financial future. And that’s a move any smart investor can get behind.
