Everyone has heard of Depreciation and most real estate investors are taking advantage of the “Straight Line” method of depreciation. But, did you know you can accelerate depreciation in parts of your property or portfolio? This is an IRS approved method, which ultimately puts more cash in your pockets. It is called;
Cost segregation is a way to accelerate the depreciation of certain real estate building and renovation costs - leading to a direct reduction in income taxes owed and a corresponding improvement in cash flow.
Using cost segregation applied to real estate is almost certain to save a you significant amounts of money if:
The property of portfolio is worth more than $500,000
You have owned it for less than 10 years.
The benefits usually outweigh the cost of the study by factors of 10 or more.
Every $1 million in property value reclassified from a 39-year to a five-year recovery period results in a net present value of spendable cash to more than;
$200,000 in your pockets now!
The way it works is;
Income taxes are reduced
Cash flow improves
Plus, Investors can claim prior years’ depreciation without amending prior returns.
Who Can Benefit from Cost Segregation?
If you own any of the below, you should be able to benefit from Cost Segregation:
Nursing Homes, Assisted Living Facilities
Auto Repair Shop
Auto Dealer Property
Hospital, medical center
Portfolio of Properties
Why Should You Care?
Cost Segregation allows you to claim 50-70% more depreciation on your commercial property. This reduces your income taxes and in turn increases your cash flow from the property.
What is Cost Segregation?
This IRS-defined engineering approach accurately classifies an investment property into two asset groups:
Structural components which have longer depreciation schedule;
Non-structural components, e.g. furniture, carpets, landscaping, plumbing, electrical, HVAC systems, parking lot which have shorter 5, 7, or 15 years depreciation schedule. So the more non-structural components the property has, the more extra depreciation you can claim.
Benefits to Investors
By shifting a portion of the property into the non-structural assets, Cost Segregation allows you to reduce your income tax by generating extra 50-75% depreciation tax deductions and thus
Increases your after-tax cash flow.
The extra depreciation basically converts ordinary rental income at your current tax bracket to tax-deferred capital gain when you exchange the property.
Of course the higher your tax bracket, the more tax savings you will get. The saving is even more if you also have to pay state income tax as Cost Segregation is also allowed in state income tax return. These tax savings tend to occur in the first 5 years of ownership. Once the extra depreciation runs out, it may be a time to evaluate if you should exchange the property and repeat the whole process again.
Cost Segregation allows you to increase tax depreciation. This is not the same as accelerated depreciation, which simply shifts a higher percentage of depreciation deduction to the early years. This accelerated depreciation is subject to Alternative Minimum Taxes while depreciation from Cost Segregation is not.
Do's and Don't
If you own commercial property valued at $500,000 or more, you should explore the benefits of Cost Segregation especially when you are at high tax brackets and can benefit from additional depreciation.
Use the Cost Segregation Calculator on CutMyFederalTaxes.com. You just need to provide: property type, building cost, your tax rate, date of purchase and it will give you an estimated tax savings. Use this as a go, no go test to see if it's worth pursuing further.
Take advantage of free estimate most Cost Segregation companies offer. It tells you the costs of Cost Segregation, and estimated potential tax savings in the first 5 years.
Don't let the cost of Cost Segregation deter you. It costs money to make more money.
Discuss the estimate provided by the Cost Segregation companies with your CPA or tax accountant to see if your CPA would advise you to proceed.
You may want to consider Cost Segregation at the time of purchase of a commercial property as part of your investment and exit strategy.
You will maximize the tax savings benefits if you hold the property for 5 years, i.e. it probably does not make sense to do Cost Segregation and sell the property shortly after that.
If you own the property for several years, the IRS allows to "catch up" underreported depreciation from prior years by filing a form 3115.
If you have remodeled and renovated your property, Cost Segregation can also recover a significant portion of the asset value, which you have abandoned.
There are many companies that can help you. We have used quite a few and can give you recommendations. As always you will need to consult with your tax advisors so that this tool can be folded into your strategic investment strategy.