Savvy real estate investors often focus their efforts on minimizing their tax liability by taking advantage of certain tax strategies within our tax law. Cost segregation is a strategic tax planning tool that has the potential to shelter taxable income by depreciating certain components of a property at an accelerated rate.
Learn what cost segregation is, how it works, who can benefit from a cost segregation study, and how recent tax reforms affect the benefits of accelerated depreciation through cost segregation.
What is depreciation?
Depreciation is the act of deducting the loss of an asset's value over time from average use and wear and tear. In real estate, residential properties are depreciated over a period of 27.5 years and commercial properties are depreciated over a period of 39 years. Most real estate uses straight-line depreciation, depreciating the asset or property as a whole over the allotted period of time.
However, there is the opportunity to accelerate depreciation or take advantage of bonus depreciation through cost segregation.
What is cost segregation?
Cost segregation is a useful tax strategy that allows real estate investors who have acquired, built, or purchased land or real property to reduce their taxable income by having a cost segregation study or segregation analysis completed on the property.
This process converts a 1250 property, which is a non-residential real property (subject to 39-year straight-line depreciation) or residential rental property (subject to 27.5-year straight-line depreciation) into 1245 property (tangible personal property), which can accelerate depreciation on certain interior and exterior components of the property over five, seven, or 15 years.
As a result, the property owner's income tax rate can be lowered because they are able to write off assets at a more accelerated rate than traditional straight depreciation limits allow, increasing their business's cash flow and profitability.
How a cost segregation study works
A cost segregation study should be completed by a professional with experience in engineering, architecture, construction, and tax accounting who can provide a formal cost segregation analysis.
The study will separate certain qualified items that would normally be considered 1250 property. This could include, for example:
- The electrical system.
- Specialized kitchen equipment.
- Wall coverings.
- A concrete slab floor.
- The ventilation system.
- Special plumbing.
- Lighting fixtures.
- The phone system.
- The computer system.
- Process piping.
- Storage tanks.
The recovery period, which is the period of time something can be depreciated, will also be separated out for these items.
Qualified assets will vary by property type and project type, and how to determine exactly what qualifies as a 1245 asset is heavily debated. Examiners can refer to the IRS's Audit Techniques Guide (ATG) Chapter 6.4 - Relevant Court Cases, which provides further information, audit techniques, and examples of proper cost segregation studies.
Who do cost segregation studies benefit?
Because a cost segregation study can cost around $10,000 to $15,000, cost segregation studies are not right for everyone. They are typically only used by commercial real estate investors or rental property owners with significant real estate activity that would benefit from a notable reduction in their federal income tax rate.
If your business is not generating substantial income or the tax savings a cost segregation analysis would provide will not exceed the initial cost, it's unlikely a cost segregation study is right for you.
When should a cost segregation study be conducted?
Most professionals recommend completing a cost segregation study immediately after the purchase, remodel, or construction of a property or within the first year thereafter for maximum tax benefits.
How the Tax Cut and Jobs Act changed cost segregation
The Tax Cut and Jobs Act (TCJA) added several provisions to the IRS code including the Section 179 deduction, which allows business owners to take a bonus depreciation of 100% for qualified assets in the first year (as defined by a cost segregation study) rather than depreciating the assets over a longer period of time. This 100% bonus deduction is only available until 2022 and will then be slowly phased out until it is completely gone by 2027.
Cost segregation in summary
If you're considering utilizing cost segregation for tax purposes, speak with your accountant to determine whether it's worthwhile and whether the cost would justify the savings. Cost segregation can equate to tens of thousands to potentially hundreds of thousands of dollars in tax savings, depending on the property, especially with the current 100% bonus depreciation, but it isn't the right move for every investor.
If you do feel you would benefit from a segregation analysis, make sure you work with a qualified professional and ensure they are conducting the study in accordance with the current standards and audit techniques provided by the IRS.
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