Real Estate Tax Savings: How Cost Segregation Works

Have you ever been told that the ultra-wealthy folks end up paying little to no taxes?

I know I have.

The fact is, anybody can benefit from the tax system if they know how to play the game. If I could go back in time (before dental school), there are two main areas I would have focused on and that is learning how:

• Money works
• The tax system works

The good news is that in this article, I’m going to give you their “secret” to save you time from having to read all 7,000 pages of the tax code.

And that secret is something called Cost Segregation.

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What is Cost Segregation in Real Estate?

Cost segregation is a tax planning tool that helps real estate investors accelerate the depreciation of their investment properties. By doing this, you can reduce your annual federal and state income tax payments, potentially increasing cash flow (which is a good thing!).

Essentially, it allows you to classify real estate assets so that you can benefit from accelerated depreciation.

Straight Line Depreciation

Property owners and investors typically spread out the cost of their residential properties (like houses or apartments) over 27.5 years. This means they divide the cost of the property by 27.5 and deduct that amount each year on their taxes.

For commercial properties (like office buildings), they do the same thing but over a longer period of time… 39 years. This process is called depreciation, and it helps reduce the amount of income tax they have to pay each year.

For more about how depreciation works, check out this video:

If you depreciate your assets on a shorter time schedule (vs straight line depreciation which is 27.5 years), then you’ll speed up your depreciation deductions and reduce the amount of income tax you pay.

Here are the main steps in a cost segregation study:

1. Identify and classify all building components.
2. Determine which components qualify for accelerated depreciation.
3. Allocate costs to individual building components.

Keep in mind that the process requires the expertise of professionals who are knowledgeable about tax laws, engineering, and construction practices.

If you’re interested in the group I personally use to perform our cost seg studies on our RV parks and mobile home parks… click HERE.

What are the Benefits of Cost Segregation?

#1. Tax Savings and Deductions

Cost segregation allows you to accelerate the depreciation deductions on certain components of your real estate property. By identifying and reclassifying these assets into shorter-lived depreciation categories, you can take advantage of faster depreciation rates.

 For instance, the Modified Accelerated Cost Recovery System (MACRS) enables you to segregate building components into different classes with varying depreciation schedules. Some common classifications include:

• 5-year property: Specifies personal property such as furniture, equipment, and carpeting.
• 15-year property: Includes land improvements like landscaping, sidewalks, and parking lots.
• 27.5-year property: Applies to residential rental property, such as apartment buildings.
• 39-year property: Pertains to non-residential, commercial property.

This results in increased tax deductions and reduced tax liability for you. A cost segregation study helps segment different components of a property’s depreciation, enabling you to save money in the long run.

#2. Improved Cash Flow

One of the most significant benefits of cost segregation is its impact on your cash flow. By accelerating depreciation deductions, you can lower your annual tax payments and increase your disposable income.

This increased cash flow allows you to reinvest in your property, pay down debt, or expand your real estate portfolio.

Here is a list of potential cash flow improvements:

• Increased annual depreciation deductions
• Lower taxable income
• Greater flexibility for future capital investments

#3. Strategic Tax Planning

If you’re a high-income earner, strategic tax planning is a MUST. These studies enable you to:

1. Determine optimal times for property acquisitions or dispositions
2. Plan for remodels, renovations, or leasehold improvements
3. Minimize the impact of taxable gains upon sale

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How Does Cost Segregation Work? 

What Is An Example of Cost Segregation?

Let’s make this easier to understand using a $1 million building purchase price and a tax rate of 32%:

Imagine you buy a commercial building for $1 million. Typically, you’d spread the cost over 39 years for tax purposes. This is called straight-line depreciation. So, each year, you’d claim a depreciation expense of $25,641 ($1 million divided by 39).

If you’re in a 32% tax bracket, your tax savings from this depreciation would be about $8,205 yearly ($25,641 multiplied by 32%).

Now, let’s say you do a cost segregation study. This study finds that $500,000 of your building’s cost is for things like furniture, fixtures, or improvements with a shorter life span. You can depreciate these costs faster:

• $100,000 a year for 5 years
• $71,429 a year for 7 years
• $33,333 a year for 15 years

For the remaining $500,000 of your building’s cost, you still use the 39-year straight-line method, which gives you an annual depreciation of $12,821.

So, in the first year, if you choose the 5-year option for the short-life property, you can claim a total depreciation of $112,821 ($100,000 for the short-life property plus $12,821 for the rest).

With a 32% tax rate, your tax savings for the year would jump to about $36,103, way more than the $8,205 you’d get without cost segregation.

By doing cost segregation, you’re getting more tax savings upfront, which means more cash in hand to invest in other things.

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Who Will Benefit From A Cost Segregation Study?

Understanding Bonus Depreciation

The Tax Cuts and Jobs Act (TCJA) introduced many changes, including enhancing bonus depreciation.

This provision allows taxpayers to immediately deduct a certain percentage of the cost of eligible property rather than spreading the deductions over the asset’s useful life.

In other words, bonus depreciation is an IRS-allowed deduction that allows a taxpayer to take a 100% deduction in the year the asset is placed in service. At least, that’s how it initially started. 

From 2018 onwards, the TCJA increased the bonus depreciation rate to 100% for qualifying property, and it’s already started to phase out (began end of 2022).

Bonus depreciation applies to new and used property, qualified leasehold improvement property, qualified retail improvement property, and qualified improvement property.

Phase Out

Here’s the phase-out threshold schedule:

• 2017 to end of 2022: 100% bonus depreciation
• 2023: 80% bonus depreciation
• 2024: 60% bonus depreciation
• 2025: 40% bonus depreciation
• 2026: 20% bonus depreciation
• 2027: 0% bonus depreciation

When Is the Ideal Time for a Cost Segregation Study?

Timing is everything with cost segregation studies. Ideally, you’d want to get one done in the same year you purchase, renovate, or construct a property.

This allows investors to optimize their tax savings while investing heavily in the building’s structure and related costs.

Look-back Study

But what if you missed that window? No worries – building owners have the option of a look-back study. This is a way to play catch-up on your tax deductions in the current tax year.

A look-back study lets you revisit your past tax returns and revise those additional depreciation deductions you might have missed in previous years. 

Frequently Asked Questions

What are the benefits of conducting a cost segregation study for commercial properties?

A cost segregation study offers several benefits for commercial property owners. By identifying and reclassifying eligible components of a building for accelerated depreciation, you can increase your tax deductions and improve cash flow. This allows you to lower your tax burden, free up capital for reinvestment, and potentially increase the present value of your property.

How can a cost segregation study impact depreciation schedules and tax savings?

Cost segregation studies help identify building components that can be depreciated over shorter periods, typically 5, 7, or 15 years, instead of the standard 27.5 or 39 years for residential and commercial properties, respectively. By accelerating depreciation, your tax savings are maximized in the early years of property ownership, improving overall cash flow and providing opportunities for reinvestment.

What aspects of a building qualify for cost segregation, and how are they categorized?

In a cost segregation study, components of a building are classified into four categories: personal property, land improvements, building structure, and land. Personal property consists of equipment, furniture, and fixtures. Land improvements involve landscaping, parking lots, and exterior lighting. The building structure is the shell of the building and its supporting components. Conducting a cost segregation study allows for the reclassification of personal property and land improvement components for accelerated depreciation.

What is the typical process and timeline for a cost segregation study?

The process for a cost segregation study begins with engaging a qualified professional, such as an engineer or tax expert, to conduct an analysis of the property. The expert will review construction documents, conduct a site visit, and identify eligible components for reclassification. They will then prepare a detailed report to support the modified depreciation schedule. The entire process typically takes about 4 to 6 weeks, depending on the size and complexity of the property.

How does bonus depreciation work in conjunction with cost segregation?

Bonus depreciation is a federal tax provision that allows for immediate expensing of a percentage of the cost of eligible property. By combining cost segregation with bonus depreciation, you can further accelerate depreciation deductions for qualifying personal property and land improvement components. This may result in even greater tax savings and increased cash flow in the early years of property ownership.

Are single-family residential properties eligible for cost segregation analysis?

Although cost segregation is typically applied to commercial real estate or residential rental properties, it may also be applied to single-family residential properties used for investment purposes. However, the benefits might not always outweigh the costs of the study for smaller properties. It’s essential to consult with a tax expert or cost segregation specialist to assess whether a cost segregation analysis may be beneficial for your single-family residential property.

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