Cost Segregation for Real Estate: What It Is And How It Works

Cost segregation in real estate are used by investors to save thousands in taxes.

Let’s face it. Maintaining and managing property is expensive. Property costs like repairs, renovations, and expansions can really add up.

And every dollar you save is a dollar you can reinvest in your business. 

This post will help you understand how cost segregation can put money back into your pockets.

The Purpose of Cost Segregation

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The purpose of cost segregation is to accelerate the rate of depreciation on your rental properties.

Depreciation is a non-cash expense that the IRS allows real estate investors to use as a deduction on their tax returns.

This deduction allows you to write-off a portion of your property’s purchase price over time.

The IRS allows you to write-off a portion of your property’s value over 27.5 years if it is a residential property, or 39 years if it is a commercial property.

This is referred to as straight-line depreciation. Under this method, the cost of your property is evenly allocated over its useful life.

On the other hand, cost segregation seeks to accelerate the rate of depreciation you can take.

It seeks to identify specific components of the property with shorter useful lives which provide greater tax deductions.

What is Cost Segregation?

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Cost segregation is a tax planning process that accelerates the rate of depreciation taken on a rental property.

It typically involves a cost segregation study, which is an examination of each element of a real estate property.

The study looks at each element of a property and splits them into different categories.

These categories are organized by useful life, which may range from 3 to 25 years depending on how the IRS classifies the property.

For example, elements like appliances, carpets, and furniture is classified as “5-year property” according to the IRS.

A cost segregation study will identify these types of elements like this. Then it will recalculate depreciation for those elements over its useful life, as opposed to the entire buildings.

For example, 5-year property worth $100,000 would provide a $20,000 annual depreciation deduction ($100,000 / 5 = $20,000).

Without a cost-segregation study, the same property would instead provide a $3,636 annual deduction ($100,000 / 27.5 = $3,636).

In this simple example, cost segregation increased your depreciation deduction by $16,364.

A cost segregation study does exactly what the name implies – you are “segregating” the cost of the property by the different components inside it and taking advantage of shorter depreciation periods.

Most real estate investors use tax CPA to help with this process.

How Cost Segregation Works

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Cost segregation studies help you pay less in taxes by increasing your depreciation tax deductions from your real estate property.

To do this, you will need a third party vendor to conduct a cost segregation study.

It typically involves the following:

• A Feasibility Analysis: This analysis will determine if cost segregation can be applied at your property. It looks at different parts of your property, like plumbing, roofs, electrical systems, and more, to see if they qualify for accelerated depreciation.

• Gathering Information: Your cost segregation vendor will need details like property appraisals, inspection reports, and purchase documents to understand your property’s value and its parts.

• Analyzing the Property: Then, they will identify the useful lives of the components of your property — in 5, 7, or 15 years as opposed to the standard periods for buildings.

• Completing a Report: Finally, they prepare a report showing how much you can save on taxes through these faster deductions.

By classifying your property into its components, you can accelerate depreciation on them, saving you money on taxes sooner. 

This process requires careful documentation and expert analysis but can lead to significant tax savings.

The Benefits of a Cost Segregation Study

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Instead of spreading out the depreciation over 27.5 (39 years for non-residential real property), this study picks out certain parts, such as HVAC, plumbing, and electrical systems, and puts them in categories that depreciate quicker. 

This means you can depreciate these investments sooner, allowing you to pay less in taxes.

Over time, a cost segregation study also helps when you fix or upgrade parts of your building. 

For example, if you install a new roof, you can claim a loss for the old one, allowing you to stretch the study’s benefits over many years. 

This method not only helps in the short term but also as you maintain and upgrade your property.

Bonus Depreciation: An Added Advantage

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In recent years, real estate investors who use cost segregation have also benefited from bonus depreciation.

Instead of depreciating components of your property evenly over 5, 7, or 15 years, it allows you to depreciate more in earlier years.

This tax provision allows investors to deduct a significant portion of a property’s purchase price as an expense in the year the property is put into service, rather than spreading it out over the asset’s “useful life.”

It basically allows you to deduct a larger portion of “short-lived” property.

Section 168 of the tax code defines property with a recovery period, or useful life, of 20 years or less as short-lived.

When you accelerate depreciation like this, there are 3 key things you need to be aware of.

1. Rental Losses

Often, the depreciation deductions exceed the income from the property, resulting in a tax-deductible loss. 

This is beneficial because it may allow you to pay no taxes on rental income and potentially offset other income.

2. Passive Income Rules

Real estate income is considered passive.

If your rental loses money, this loss is considered passive and you can only use it to lower your passive income.

However, if you qualify as a real estate professional, you can apply these losses more broadly, even with ordinary or earned income.

3. Depreciation Recapture

While depreciation deductions can lower your tax bill, they also decrease your property’s cost basis. 

Upon selling, you would have to “recapture” the depreciation you took, potentially increasing your tax liability unless you take strategic measures.

For example, let’s say you bought a property for $200,000 and depreciate it down to $0. Then you decide to sell it in the future for $300,000.

Instead of paying capital gains tax on the difference between your purchase price of $200,000 and sales price of $300,000, you would pay capital gains tax on the difference between your cost basis of $0 and sales price of $300,000.

So instead of having a $100,000 capital gain, you would have a $300,000 capital gain. And that may come as a surprise for many people.

Fortunately, there are ways to get around this with tax strategies like 1031 Exchange and Deferred Sales Trusts.

What is a 1031 exchange?

A 1031 exchange is a way for investors to swap one investment property for another, thereby deferring the payment of any capital gains taxes from the sale. 

This process, named after Section 1031 of the Internal Revenue Code, is a popular tactic among real estate professionals. 

It allows you to keep investing in new properties without the immediate tax hit. 

But, as with any tax strategy, it’s crucial you get advice from legal and tax experts.

What about the Deferred Sales Trust?

It’s a newer strategy, aimed at investors looking for alternatives to the 1031 Exchange. It may be beneficial when finding a similar property to exchange is difficult or undesirable. 

As defined under Section 453 of the IRC, it operates similarly to an installment sale, allowing you to recognize and defer capital gains tax over a set period that you decide. 

While it offers a way to potentially lessen risks associated with direct seller financing, it is important to review this strategy with your legal and tax advisors since it is relatively new and there is very little IRS guidance at this point in time.

The Bottom Line

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Cost segregation in real estate is a strategic tax move that business owners use to boost their cash flow and minimize their tax liabilities. 

While the concept might seem complex, the right tax planning can guide you through the details, making it a potentially lucrative option for those looking to optimize their investment returns.