How Cost Segregation Helps Reduce Tax Liability
If you are a real estate investor, chances are you already know what cost segregation is. You might use it to minimize your tax liability. If this term is foreign to you, essentially, cost segregation is a strategic tax planning tool that shelters taxable income by depreciating certain components of a property at an accelerated rate.
For real estate companies, cost segregation is a way to adjust capital received by the company.
Cost segregation benefits a company because of doing away with obsolete material. It also benefits the real estate investor because of the potential lost capital due to depreciation. This is the act of deducting the loss of an asset’s value over time from average use and wear and tear. Using historical cost information rather than actual figures, an investor can often come across assets that continue to perform for a periodically changing company.
Cost Segregation for Real Estate Investors
When it comes to real estate, residential properties are usually depreciated over a period of approximately 27 years. Commercial properties are depreciated over a period of almost 40 years. However, you can accelerate depreciation through cost segregation.
For example, if a small condo complex that is worth $1 million was being depreciated over 27.5 years, an investor could take a depreciation deduction of approximately $36,300 a year. Better yet, if that depreciation was taken over a 7-year period, you could take a whopping $142,000 annual depreciation deduction.
Furthermore, real estate investors who have acquired, built or purchased land or property can potentially reduce their taxable income by having a cost segregation study or segregation analysis completed on said property.
What is a Cost Segregation Study?
Many real estate investors assume a cost segregation study will be done by an accountant. However, they are usually performed by engineering firms. This is due to the fact that these studies require the physical inspection of a property and a “re-classification” of various physical aspects of a structure. Be aware that depreciation deductions only count the value of the building, not the land it’s on. Additionally, certain parts of a building deteriorate faster than others, so you can take these deductions at an accelerated rate.
As an investor, you should also know that cost segregation studies can be performed retroactively on properties bought, remodeled or expanded since 1987. This is also known as a “look-back” study. It is a great opportunity to reduce your income taxes. This enables you to take the whole unrecognized depreciation deduction in the year of the cost segregation study, instead of waiting to take the depreciation over the 5, 7 or 15-year depreciation term of the asset.
Cost segregation allows you to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes. By utilizing this strategy, your wallet will thank you.