If you’ve ever found yourself in discussions about how the rich seem to pay less taxes, then don’t worry; you’re not alone. However, we don’t have to begrudge the rich for knowing how to navigate the tax system. The truth is, anyone—even you—can benefit from the tax system if you know how to play by the rules. Fortunately, there’s no need for you to dig deep to know that real estate investors use to pay less or no taxes on their real estate income. The answer is simple: Cost Segregation Services.
What is Cost Segregation?
Cost segregation is a tax strategy that real estate owners use to expedite depreciation deductions. This leads to an increase in cash flow and reduction of federal and state income taxes they pay on their rental income.
Real estate, sans a cost segregation study, is divided into two categories: Land and Building. Land does not depreciate, while the Building, on the other hand, depreciates over 27.5 years (for residential buildings) and 39 years (for commercial buildings).
Although the depreciation is beneficial, the yearly tax deduction is rather insignificant. Getting a cost segregation study done by seasoned engineers and/or certified public accountants (CPAs), following the Internal Revenue Code and rules of the Unit of Property can segregate the building into categories such as Property and Land Improvement.
What Is a Cost Segregation Study and What Is Involved in It?
Property owners and real estate investors usually depreciate residential rental property over 27.5 years and commercial property over 39 years, for income tax purposes.
However, a building (whether a residence, warehouse, office building, or any other real estate property) does not just refer to the structure alone. It also includes other elements, including lighting, plumbing fixtures, carpeting, fencing, sidewalks, and many more.
It is possible to depreciate these assets by over five, seven, or fifteen years if you were to purchase them by themselves. However, they are usually purchased as part of a building acquisition or development and they are written off over the same life expectancy of the building: 27.5 or 39 years.
Cost segregation studies looks into each element of a property and divides them into different categories. This allows building and real estate property owners to benefit from an accelerated depreciation timeline for some of the building’s parts and components.
Why Do Property Owners Have to Conduct Cost Segregation Studies?
Dividing or segregating the costs of a property is important because there are financial benefits property owners can gain from it. Although there is an upfront cost for such studies, the tax savings from accelerating depreciation deductions can lead to more and better cash flow in the years to come.
With cost segregations services or studies, property owners get the benefit of time and value of money. But, this also means that if property owners have no long-term plans on holding the property, they may not benefit at all from having a cost segregation study done. This is because any up-front benefits are negated upon the sale of the property.
Who Conducts Cost Segregation Services?
You may feel that it’s a lot more cost-efficient to conduct such activity on your own. However, it isn’t advisable as it’s simply not practical. Cost segregation studies usually involve the expertise of a team of tax advisers and engineers. These experts work together to determine which parts or components of the building should be included in a specific category and how much each component costs on its own.
How Does Cost Segregation Work?
The main purpose of a cost segregation study is to determine all costs related to the property in question. These costs can be depreciated in the span of five, seven, up to fifteen years –or written off faster due to bonus depreciation, which is at 100% through 2022.
To do this, your advisory team will check and evaluate all available property records, cost details, inspections, and blueprints. They may also conduct physical inspections and site visits of the property.
Are Cost Segregation Services Worth It?
The answer really depends on the kind of situation you have which is unique to your own. This is why it’s important to enlist the help of a tax advisor in the process. If a cost segregation study is necessary for your specific situation, you’ll end up saving money on income taxes and increase your cash flow at the same time.
With the 2017 Tax Cuts and Jobs Act, used property can now qualify for 100% bonus depreciation. This can be applied on any asset whose tax lives are around 20 years or less. What does this mean? Well basically, it means that you can write off the assets in the Personal Property and Land Improvements categories in the first year. Bonus depreciation is said to be phased out in a few years, so it would be wise to take advantage of it while you can.
The bonus depreciation rate will be 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026. In 2027 and in the later years, the bonus depreciation will be at 0%. But even without bonus depreciation, building and property owners can still benefit from cost segregation services due to depreciating the building components over five, seven, and fifteen years, as opposed to depreciating the building over 27.5 or 39 years.
Does Your Business Qualify for a Cost Segregation Study?
Building and real estate owners with tax liabilities are the ones that benefit the most from cost segregation studies. The most common candidates that benefit from accelerated depreciation this study include individuals, corporations, partnerships and trusts that have:
- Newly purchased or constructed property amounting to more than $1 million
- Spent over $300,000 on remodeling, renovation, or leasehold improvements
Cost segregation studies usually take around four to eight weeks to complete from the time all necessary information is collected. This process includes:
- Collecting information and data
- An in-person walkthrough or inspection of the property in question
- The analysis
- Review and assessment confirming whether the tax positions are supportable