What is cost segregation? How can it help you?

Understanding what is cost segregation in real estate and its ins and outs is important for accredited property investors. Especially, those who want to maximize their after-tax returns. When done right, cost segregation can significantly boost the net profit from a real estate investment.

In this article, we’ll break down the concept of cost segregation, how it works, and why it’s such a game-changer for real estate investors.

So, what is cost segregation in real estate?

Cost segregation is a nifty tax strategy that real estate investors can use to speed up depreciation deductions, which helps boost cash flow and cut down on taxable income. This IRS-approved technique of breaking down the components and improvements of properties is useful for those owning residential properties, commercial properties, and rental properties. 

For example, you can reclassify your assets as:

• Personal property (5-7 years): Things such as furniture, fixtures, carpeting, and some electrical and plumbing fixtures.
• Land improvements (15 years): Includes parking lots, landscaping, and outdoor lighting.

By laying down the depreciation expenses, investors can delay paying federal and state income taxes, which improves the property’s cash flow during the initial stages of the real estate investment. 

How does cost segregation work?

The Tax Cuts and Jobs Act (TCJA) of 2017 brought about big changes to the tax code that benefit real estate investors even more. One of the coolest changes is the 100% bonus depreciation. This allows property owners to immediately write off the cost of certain property improvements and personal property in the year they’re put into service.

Under the TCJA, 100% bonus depreciation applies to both new and used property bought and put into service after September 27, 2017, and before January 1, 2023. This means real estate investors can write off the full cost of qualifying assets in the first year, leading to huge tax savings right away.

Let’s understand this in detail. Normally, you’d depreciate an entire property over a long period, like 27.5 or 39 years. But with cost segregation, you can break down the property into parts with shorter lifespans (5, 7, or 15 years), such as personal property, land improvements, and certain building components. 

When you use this strategy, you can push more depreciation upfront on these shorter-lived assets and lower your taxable income in the early years of owning the property. This depreciation lets property owners recover the cost of their investment through yearly deductions. And, this can lead to big tax savings.  

Cost segregation can help you get a quicker return on investment (ROI) and boost the overall financial performance of your commercial real estate venture.

Explaining cost segregation with an example

Let’s say a real estate investor purchases a commercial rental property for $3 million. Under normal circumstances, they would depreciate the building over 39 years. 

The traditional depreciation scenario would be

• Depreciable basis: $3,000,000
• Annual depreciation (39 years): $76,923

The cost segregation scenario would be

• Depreciable basis: $3,000,000
• Personal property (5 years): $450,000
• Land improvements (15 years): $300,000
• Remaining building (39 years): $2,250,000

With cost segregation, the investor can accelerate depreciation deductions for personal property and land improvements:

First 5 years

• Personal property depreciation: $90,000/year
• Land improvements depreciation: $20,000/year
• Building depreciation: $57,692/year

Total depreciation: $167,692/year

Therefore, by using cost segregation, the investor can significantly reduce taxable rental income and increase cash flow.

What are the financial advantages of real estate cost segregation?

• This strategy translates to more cash flow. By speeding up depreciation deductions, you can significantly boost your cash flow in the early years of owning a property. This means more money for reinvesting or other business needs.
• It offers big tax savings. Accelerated depreciation leads to major tax savings by cutting down on your taxable income. Lower taxable income means you pay less in federal and state income taxes.
• It offers better ROI. With extra cash from tax savings, real estate investors can improve their investment returns and grow their portfolios faster.

Are there any drawbacks to a cost segregation study?

There are a few potential downsides to consider:

• Hiring a qualified professional to conduct a cost segregation study can be pricey, especially for small businesses. Of course, it’s an investment but the fees can add up.
• You’ll need to gather a lot of documents for the specialist. This includes appraisals, home inspection reports, and other records. This can be time-consuming and a bit of a hassle.
• The IRS might take a closer look at your cost segregation study. They will want to ensure everything’s above board and follows tax laws. This is why it’s crucial to hire a qualified expert, even if it means spending more, to make sure everything’s done correctly and you’re covered.

Who gains the most from real estate cost segregation?

Cost segregation works best for properties with a high basis and lots of land improvements or personal property components. Also, investors planning to hold properties for a long time benefit more from accelerated depreciation. And, real estate investors in higher tax brackets gain more from the tax savings that cost segregation brings.

How can I implement cost segregation in my real estate investments?

For savvy real estate investors, cost segregation is a must-have tool for optimizing tax strategies and boosting investment returns. 

To get started with cost segregation, real estate investors usually hire a cost segregation specialist. These pros conduct detailed analyses and prepare reports that follow IRS rules. The cost of a study varies, but the tax savings and increased cash flow it generates usually make it worth it. That said, while cost segregation can cut down federal income tax liabilities, you also need to consider state income tax implications. Some states follow federal depreciation rules, while others have different regulations. It’s crucial to consult with a tax professional who knows both federal and state tax codes to get the most benefits.

Read more: What is mills in real estate?

What is the cost segregation process like?

To start, you’ll need to get a cost segregation study from an accredited financial firm with experience in construction, tax law, and accounting. Remember that you can only do this once for each investment property you own.

First up is the feasibility analysis. This step checks if your property is a good fit for cost segregation. The firm looks at various components such as plumbing, your roofing system, and electrical systems. If you could buy these separately, they’d be depreciated over 5-15 years instead of the longer 27.5 years for residential buildings or 39 years for commercial properties.

Next, the firm collects all the necessary documents, such as recent home appraisals, inspection reports, and closing documents, to figure out the value of the property and its different parts.

Then, there’s the property analysis. The team digs into the property details, pinpointing operating costs that can be depreciated faster, over 5, 7, or 15 years. They do this by reviewing documents such as blueprints, property records, and inspection reports.

Finally, they put together a final report that outlines how much you can save on income taxes by using cost segregation strategies to speed up the depreciation of certain parts of the property.

Key takeaway

Cost segregation gives real estate investors a fantastic way to improve cash flow and cut tax liabilities through accelerated depreciation deductions. The Tax Cuts and Jobs Act has made these benefits even better. By strategically using cost segregation, real estate investors can achieve big tax savings, enhance investment returns, and grow their portfolios more effectively.

For anyone involved in real estate investments, especially with residential properties and rental properties, this strategy is worth looking into. 

Of course, it requires detailed analysis and professional guidance. But, the potential benefits are huge. 

Written by Ramona Sinha. August 5, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.