Have you ever discussed how wealthy people appear to pay less in taxes? If so, you are not the single one. The truth is that as long as you understand the fundamentals of the game, anyone can profit from our tax system. Fortunately, there is a tax “secret” that real estate investors employ to minimize or completely avoid paying taxes on their rental real estate profits.

Cost Segregation is the term for it.

What does mean cost segregation in real estate?

Cost segregation is an IRS-approved depreciation tool that allows investors who have built, purchased, or remodeled their real estate holdings to accelerate depreciation deductions. An analysis of cost segregation is used to achieve this. A lot of investors are searching for strategies to maximize their tax deferral and expand their investing options. Cost segregation in real estate offers many benefits for investors and property owners, including increased cash flow. Pairing cost segregation and a 1031 exchange is one of the most valuable tax strategies investors can utilize, helping reduce operating costs and defer capital gains.

The Role Of Depreciation

 Depreciation allocates the cost of a tangible asset over its useful life and differs depending on whether the property is residential or commercial. Both utilize “straight line” depreciation methods, which means that in each case the property is deducted evenly from an income statement over time.

• Apartment buildings and other residential real estate typically depreciate over 27.5 years;
• Commercial Real Property is generally depreciated over 39 years.

Property defined as personal property has always been allowed accelerated depreciation. This accelerated method of depreciation represents the value of a cost segregation study. A cost segregation study reclassifies value from real property to personal property, allowing for an investor to obtain tax benefits by writing off those assets in a much more expeditious fashion. The Tax Reform Act of 2018 also allows for qualified personal property to be expensed immediately upon acquisition. This means that in certain situations, 100% of the depreciation deductions can be taken in the first year of ownership!

The foregoing makes it clear that an investor can save large sums of money by strategically utilizing depreciation and cost segregation in their tax planning analysis. For example, $1,000,000 of depreciable value using a 39-year straight-line depreciation will produce an annual depreciation deduction of $25,641. The identical $1,000,000 will, however, result in a primary-yr deduction of $142,857 if depreciated over a seven-year length and an astounding $2 hundred 000 if depreciated over five months! Therefore, a property owner can generate large tax savings by reclassifying parts of a building from real property (§1250 property) to personal property (§1245 property).

How A Cost Segregation In Real Estate Study Works

An investor can reclassify real property to personal property on specific assets for depreciation purposes via a cost segregation study. For example, a building’s foundation and structural components can be depreciated over 27.5 years instead of 39 years if they are considered “personal property.” To have a valid cost segregation study, the IRS requires that it be performed by companies or accounting firms that specialize in this area and employ engineers and/or construction management professionals. Thorough knowledge of accounting, tax law, and construction is therefore required for a comprehensive study.

The real estate should be broken down into four categories in the engineering report: land, land improvements, building/structural components, and tangible personal property. A good cost segregation study reclassifies at least 20-30% of a building as personal property for depreciation purposes, which allows for increased depreciation deductions and correspondingly reduced taxes.

A cost segregation study has advantages such as improved cash flow and lower taxes. However, it may potentially complicate a future like-kind exchange under Section 1031 if the replacement property contains less Section 1245 personal property than the relinquished property had. To avoid depreciation recapture, the investor may need to find a replacement property that either had a valid cost segregation study or perform a study on the replacement property before closing.

The immediate expensing of certain qualifying costs after a cost segregation study under the new Tax Reform can potentially create tax consequences when the property is sold. If those items (that have a zero basis) have value when sold, the seller will have to recapture the prior depreciation (to the extent of the gain) as ordinary income. It may be advantageous to employ an appraiser at the time of sale in order to ascertain whether any previously reclassified personal property has any remaining value. Even though the new tax legislation greatly favors quick expensing, it’s crucial to be sure the benefits outweigh the drawbacks.

The Benefits Of Cost Segregation In Real Estate Study

A cost segregation study can be used by an investor to reclassify real property as personal property on particular assets for depreciation purposes. Residential and commercial property owners can enjoy substantial tax cuts and advantageous write-offs when an asset becomes damaged or needs to be completed and replaced.

Some of its major benefits include:

1. Increased Cash Flow
2. Accelerated Depreciation
3. Significant Tax Savings
4. Funding Early Retirement Losses
5. Retroactive Savings
6. Maximizing Depreciation Deductions On New Construction Or Renovation

Cost Sеgrеgation In Real Estate  Analysis Examplе

Say you own a warеhousе that is valuеd at $800,000. If you wеrе to follow thе standard formula of dеprеciating your warеhousе for 39 yеars, your total dеprеciation writе-off еach yеar would bе $20,512. If you arе taxеd at a 37% fеdеral incomе tax ratе, you would savе about $4,600 on your taxеs еach yеar that you own your propеrty during this 39-yеar dеprеciation pеriod.

Suppose you pay for a cost sеgrеgation study. In that case, your tеam might discovеr that you can dеprеciatе $100,000 of this property’s plumbing fixturеs during a 5-yеar pеriod, $100,000 of еlеctrical fixturеs that can bе dеprеciatеd during seven yеars and $100,000 that you spеnt on nеw curbs, sidеwalks and storm sеwеrs that can bе dеprеciatеd during a pеriod of 15 yеars.

This now means that your building is worth $500,000 whilе thе systеms еligiblе for accеlеratеd dеprеciation arе worth $300,000.

Armеd with this information, you can now claim morе dеprеciation on your taxеs during thеsе yеars. In thе еxamplе abovе, in thе first year after you complеtе your cost sеgrеgation study you could writе off about $12,820 in dеprеciation costs for your building; $20,000 for thе plumbing fixturеs that can bе dеprеciatеd ovеr five yеars; about $14,285 for thе еlеctrical fixturеs that can bе dеprеciatеd ovеr seven yеars; and $5,000 for thе еxtеrior improvеmеnts that can bе dеprеciatеd ovеr 15 yеars.

Again, assuming a tax rate of 37%, this would result in a first-yеar tax savings of about $11,689. That’s a big incrеasе ovеr thе $4,600 in savings you’d rеalizе without a cost sеgrеgation analysis.

You can only perform a cost sеgrеgation onе timе on any invеstmеnt property that you own.

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Conclusion 

Ultimately, cost segregation is a highly effective strategy for all passive investors looking to know the true, actual value of their assets. Cost segregation provides residential real estate investors with an additional opportunity to save money and maximize the profitability of what they already own. It is a powerful strategy that the right CPA can use to your advantage.

Even though there is a steep getting-to-know curve associated with actual estate investing, folks who use the offerings of prison and tax professionals knowledgeable within the area can acquire substantial economic rewards on the way to valuable resources in their achievement.

Download our free guide for 1031 Exchanges Tax Planning With Cost Segregation Studies.