How Cost Segregation Helps Investors Save on Taxes

Cost segregation has been a highly effective tool that real estate investors have used for many years to increase their wealth and bolster their portfolios. While this tax-deferring strategy doesn’t allow you to avoid paying taxes, it does give you the opportunity to save money on your taxes until a later date. This tax strategy is also easy to take advantage of and isn’t just available to seasoned investors. In this article, you’ll learn about how cost segregation in real estate can reduce the taxes you owe. 

What Is Cost Segregation in Real Estate?

Cost segregation is a common strategy that allows you to defer taxes in a manner that accelerates the depreciation of your property on paper. By accelerating your depreciation expenses, you can write off this money in your annual tax return, which will lower your tax liabilities. 

Rental properties and other forms of real estate typically consist of the land you purchase and the building that’s situated on it. IRS guidelines state that the building can be depreciated over a period of 27.5 years. Let’s say that the building located on your property has a value of $1 million. You could write off $36,363 each year as depreciation expenses to substantially reduce your taxable income.

Keep in mind, however, that some of the components in your investment property could depreciate at a faster rate. These components include:

• Fences
• Walkways
• Roofs
• Flooring
• Appliances
• Furniture
• Electrical wiring

Cost segregation allows you to accelerate the depreciation of the above components into intervals of 5-15 years. If you want to take advantage of this tax benefit, consider segregating your real estate into four separate components, which include the:

• Building
• Land
• Improvements to land
• Personal property

How Does Cost Segregation Work?

As mentioned above, you can write off more than $36,000 per year on a building that’s valued at $1 million with standard depreciation rules. If, however, you choose to perform cost segregation, the results can differ substantially. Let’s say that around 30% of your property depreciates in five years after cost segregation is performed. In this scenario, you’d be able to write off around $60,000 for the next five years from your taxable income. 

The Tax Cuts and Jobs Act that was passed in 2017 also allows investors to use a bonus depreciation of 100% on qualified properties. If you combine bonus depreciation with the cost segregation calculations, the $300,000 that you’d depreciate over a period of five years could be written off in the very first year.

Along with substantially improving your cash flow, this strategy gives you money that you can use to make improvements to your property that increase its value and help you strengthen your cash flows even further. 

While investors are currently able to take advantage of the 100% bonus depreciation, the amount is set to drop by 20% each year starting in the 2023 tax year. This means that bonus depreciation will only be 80% in 2023 and 60% in 2024. It’s set to phase out in 2027 unless Congress extends it. 

Downsides to Cost Segregation

Cost segregation is a highly useful tax benefit that most investors should consider taking advantage of. However, there are a couple issues that you might want to know about. In order to segregate property components into different groups, you’ll need to obtain a cost segregation study, which can cost upwards of $20,000 depending on the age of the property, the type of building, and the location. The study could also take anywhere from 1-2 months to complete. If any of the personal property in the building is disposed of, depreciation recapture might occur.

How Cost Segregation Helps Passive Investors Save on Taxes

While residential real estate is depreciable over 27.5 years, commercial real estate depreciates over 39 years. If a commercial building is worth $20 million, a syndicator can deduct around $512,820 from the property’s net operating income. Individual investors will obtain a portion of this deduction that’s equal to their stake in the real estate deal. If you have a 1% stake in the commercial property, your allowable deduction would amount to $5,128. 

When using the cost segregation study mentioned previously, items like appliances, window treatments, and carpet could have a five-year depreciation. Other items like the parking lot and sidewalks could depreciate over 15 years. The rest of the structure would depreciate over the standard 39-year period. If 25% of the building consists of items that depreciate in 5-15 years, 100% of these items are able to be written off with the bonus depreciation rule. 

The write-off expense would now amount to $5 million for the first year. As a passive investor with a 1% stake, you could earn a deduction of $50,000, which is around 10 times higher than the standard deduction of $5,128. Keep in mind that the taxes will only remain deferred until the property is sold. Even though you’ll eventually owe these taxes, accelerating depreciation allows you to earn more funds that can be used as capital for additional investments. 

While you may owe a sizable tax liability when you receive your capital by the syndicator after the property is sold, you can continue to defer these taxes by using the proceeds from the first investment to enter another syndication. 

No matter how your investment portfolio is currently structured, cost segregation provides you with an opportunity to increase cash flows to further strengthen your portfolio. Now that the 100% bonus depreciation is scheduled to phase out gradually over the next few years, today may be the best time to use the cost segregation strategy. 

To learn more about how passive real estate syndication investing can work for you click the link below and schedule a call with one of our team members to discuss any additional questions you may have and if were the right fit for you.