In the realm of real estate investment getting the highest returns and maximizing cash flow are among the top priorities. But many real estate property owners, investors, and their tax advisors overlook studies on cost segregation. To understand how cost segregation fits into broader tax planning strategies, review our comprehensive IRS tax guide .
This is a missed opportunity for the real estate client you represent since cost segregation studies could greatly increase the profit and decrease the tax burden on the residential and non-residential rental properties.
A cost segregation analysis will also allow you to defer the federal and state income tax that are due on those investments.
What is Cost Segregation study?
Cost segregation is an examination of each component of a building, divides the elements into various categories, and permits the property owner to benefit from an enhanced depreciation schedule for certain of these building components. While a cost segregation research is a one-time expense however, the tax savings resulting due to accelerating deductions for depreciation can be significant and result in a substantial increase in cash flow over a period of time. For guidance on IRS rules regarding depreciation and property classification, refer to our IRS tax guide for real estate depreciation strategies.
Let’s discuss the advantages from conducting cost segregation study in greater depth.
Five essential aspects to be considered
1. Accelerated Depreciation.
The main benefit of conducting a cost segregation study is the possibility to accelerate depreciation deductions.
Typically, depreciation for non-residential property is spread across 39 years, and 27.5 years for residential rental homes. A cost segregation study permits the reclassification of some elements of a property for instance, personal property, land improvements, or particular building elements to depreciable life spans that are shorter generally between 5, 7 and 15 years.
It is important to keep in mind that the land itself cannot be depreciated.
A cost segregation research typically requires expertise in construction, engineering and taxation. Through accelerating depreciation, your clients who own real estate can substantially boost tax deductions prior to the period of investment. By doing this, they can lower their tax deductible income, and increase the flow of cash.
Cost segregation is particularly effective when it is combined with bonus depreciation, which is a tax incentive that allows businesses to deduct substantial portions of the cost of purchasing eligible business assets during the year in which they are put in service.
As per the Tax Cuts and Jobs Act of 2017, the bonus depreciation rate was temporarily increased up to 100% for qualified assets put into service on or after September 27th, 2017 and prior to January 1st 2023. Beginning in 2023, however, this bonus rate was cut by 20% annually until it is phased out entirely by the end of 2026.
Assets that qualify for bonus depreciation tend to be those that fall under the Modified Accelerated Cost Recovery System (MACRS) with a maximum recovery that is 20 years or less which includes 15 years of qualified improvement Property.
2. Transaction and property type.
Cost segregation studies can be used for all kinds of properties that are commercial or rentals, both being ideal candidates.
Properties where you pay for the property or renovation costs result in an amortizable basis that exceeds $500,000 are ideally suited for cost segregation study. The most common breakdown of transactions and property types include:
- Commercial buildings: The type of property comprises structures such as office structures, malls, hotels, shopping centers, restaurants, resorts, golf courses, heavy and light manufacturing facilities such as wineries and auto dealerships, as well as warehouses, distribution centers, and more.
- Residential rental properties: Include multi-family housing units, apartment complexes, and short-term as well as long-term rentals.
- Types of transactions: Suitable transactions are those that have recently been purchased as well as newly constructed buildings. properties that have gone through significant improvements or expansions, and properties on a stepped-up basis usually because of inheritance or other transfer.
3. Optimal timing for a study
The ideal time for the cost segregation study could differ based on the particular tax situations. Conducting the study in conjunction with or right after the purchase or construction of a property could result in the immediate benefits of accelerated deductions for depreciation.
Additionally, conducting a thorough review following significant construction or renovations can be beneficial since it can help identify elements which are eligible for accelerated depreciation.
Cost segregation studies may also be carried out retrospectively on buildings that are operating for a long time. This permits property owners to get back depreciation they missed by adjusting their accounting procedures which can result in large one-time deductions.
Coordination of timetables for cost segregation study along with tax planning strategies that are more broad can benefit your clients, especially during the years they are expecting to earn more income. It’s because depreciation that is accelerated can reduce this amount and also reduce tax burdens.
Learn more about IRS-approved methods for maximizing depreciation and minimizing tax liability in our full IRS tax filing and compliance guide.
4. Increased cash flow
As previously mentioned, the cost segregation study can accelerate deductions for depreciation, which allows investors to benefit from tax reductions more quickly than the normal depreciation schedule allows. This can boost cash flow, which could be used to invest in the property to fund enhancements, expansions, or any other projects that increase value.
If done at the right moment, the cost segregation study will help your client to claim a loss on a disposition for assets that have been removed from service or being upgraded.
5. Audit and compliance support
Cost segregation studies performed by certified professionals conform with IRS guidelines and procedures. This helps ensure compliance with tax regulations.
If there is the possibility of IRS review, precise documents and analysis provided by a study on cost segregation can be used as evidence to support deductions for depreciation. This will reduce the possibility of penalties and disputes.
Benefits of cost segregation
The benefits of a cost segregation study go beyond immediate tax savings, it can significantly enhance cash flow, improve ROI, and create opportunities for reinvestment. When aligned with a broader real estate tax strategy for maximizing investment efficiency, investors can take full advantage of these benefits while minimizing long-term tax liabilities.
The advantages from a cost segregation study can be proven for real estate investors looking to maximize tax efficiency, boost cash flow and increase returns on investments.
Through leveraging acceleration in depreciation, increasing cash flow and getting a better understanding of valuation of assets, your property clients will be able to maximize the value in their business properties.
As the market for real estate changes and costs are segregated, it continues to be a viable strategy to increase profitability and ensure long-term success in a soaring inflationary market.
For a complete resource on IRS rules, depreciation strategies, and real estate tax planning, review our comprehensive IRS tax guide for real estate investors.
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