Beyond Bending Tell You How
Real estate investors and property owners are always on the lookout for ways to maximize their tax benefits and increase their cash flow. One strategy that has gained popularity in recent years is cost segregation, a tax planning method that allows property owners to accelerate depreciation deductions and reduce their tax liabilities. Cost segregation can be particularly beneficial for commercial and residential real estate owners who have invested in properties with significant improvement costs.
In this article, we will discuss the basics of cost segregation and how it can help real estate investors save money on taxes. We will also cover the criteria for cost segregation, the benefits and drawbacks of this strategy, and some common misconceptions about cost segregation. By the end of this article, you’ll have a better understanding of how cost segregation works and whether it’s right for your real estate investment portfolio.
What is Cost Segregation?
Cost segregation is a tax planning method that involves identifying and reclassifying building costs into shorter recovery periods for tax purposes. In other words, it allows property owners to separate certain assets that would typically be depreciated over a longer period and reclassify them as assets that can be depreciated over a shorter period. The result is an increase in current depreciation deductions, which can help reduce the property owner’s tax liability and increase cash flow.
Cost segregation is not a new concept; it has been around since the 1950s. However, it gained more attention in the 1990s when the IRS issued guidelines for cost segregation studies. These guidelines made it easier for property owners to qualify for cost segregation and provided more clarity on the process.
Criteria for Cost Segregation
Not all properties qualify for cost segregation. To be eligible, a property must meet certain criteria:
- The property must be owned by a taxpayer who pays federal income taxes.
- The property must be a commercial or residential rental property.
- The property must have been placed in service after 1986.
- The property must have a cost basis of at least $500,000.
Additionally, the property owner must be able to provide detailed records of the property’s construction costs, including invoices, receipts, and contracts. This information is necessary to identify the specific assets that can be reclassified for depreciation purposes.
The Benefits of Cost Segregation
Cost segregation can provide several benefits to real estate investors and property owners:
- Accelerated depreciation: By reclassifying certain assets, property owners can accelerate depreciation deductions and reduce their tax liability in the early years of ownership.
- Increased cash flow: By reducing tax liabilities, property owners can increase their cash flow and reinvest in their properties, pay down debt, or pursue other investment opportunities.
- Improved financial reporting: Cost segregation studies can provide more accurate financial reporting by identifying and valuing specific assets within a property.
- Tax savings: Depending on the property and the cost segregation study, property owners can save significant amounts of money on taxes over the life of the property.
The Drawbacks of Cost Segregation
While cost segregation can be a valuable tax planning tool, it is not without its drawbacks:
- Upfront costs: Cost segregation studies can be expensive, and property owners may need to pay for the study upfront before realizing any tax benefits.
- Increased audit risk: Cost segregation studies are more likely to be audited by the IRS, so property owners should ensure that their studies are conducted by reputable firms and follow IRS guidelines.
- Potential recapture tax: If a property is sold before the end of its useful life, the property owner may be subject to a recapture tax on the accelerated depreciation deductions taken through cost segregation.
Common Misconceptions About Cost Segregation
There are several misconceptions about cost segregation that property owners should be aware of:
- Cost segregation is only for new buildings: While cost segregation is most commonly used for new buildings, it can also be applied to older buildings that have undergone significant renovations or improvements.
- Cost segregation is only for large properties: Cost segregation can be beneficial for properties of all sizes, as long as they meet the eligibility criteria.
- Cost segregation is only for commercial properties: While cost segregation is commonly used for commercial properties, it can also be applied to residential rental properties.
The Cost Segregation Process
The cost segregation process typically involves the following steps:
- Engage a qualified cost segregation firm: Property owners should work with a reputable firm that has experience in cost segregation studies and follows IRS guidelines.
- Review property records: The cost segregation firm will review the property’s construction records, including invoices, receipts, and contracts, to identify the specific assets that can be reclassified for depreciation purposes.
- Perform site inspection: The cost segregation firm will conduct a site inspection to identify any assets that may have been missed in the review of records.
- Prepare cost segregation report: The cost segregation firm will prepare a detailed report that outlines the assets that have been reclassified and the resulting tax benefits.
- File amended tax return: The property owner will need to file an amended tax return to claim the accelerated depreciation deductions.
Real-Life Example of Cost Segregation
Let’s look at a real-life example of how cost segregation can benefit a property owner. Assume that a commercial property owner purchased a building for $1 million, with $200,000 allocated to land and $800,000 allocated to the building. The property owner engages a cost segregation firm to conduct a study and reclassify certain assets for depreciation purposes.
After the cost segregation study, the property owner is able to reclassify $300,000 of building costs into assets that can be depreciated over 5 years instead of 39 years. This results in an increase in current depreciation deductions of $53,846 per year for the first 5 years of ownership. Assuming a tax rate of 35%, the property owner would save $18,999 in taxes per year for the first 5 years of ownership.
People Also Ask
Here are some common questions related to cost segregation:
What is a cost segregation study?
A cost segregation study is a tax planning method that involves identifying and reclassifying building costs into shorter recovery periods for tax purposes. The result is an increase in current depreciation deductions, which can help reduce the property owner’s tax liability and increase cash flow.
How much does a cost segregation study cost?
The cost of a cost segregation study can vary depending on the size and complexity of the property. Typically, cost segregation studies can cost anywhere from $5,000 to $50,000 or more. However, the potential tax savings from a cost segregation study can far outweigh the upfront cost.
Is cost segregation legal?
Yes, cost segregation is a legal tax planning method that has been around for decades. However, property owners should ensure that their cost segregation studies are conducted by reputable firms and follow IRS guidelines to avoid audit risk.
Can cost segregation be applied to residential rental properties?
Yes, cost segregation can be applied to residential rental properties as long as they meet the eligibility criteria.
What is the recapture tax?
The recapture tax is a tax on the accelerated depreciation deductions taken through cost segregation if a property is sold before the end of its useful life. The recapture tax is calculated as the difference between the accelerated depreciation taken and the depreciation that would have been taken under the standard recovery period.
Conclusion
Cost segregation can be an effective tax planning tool for real estate investors and property owners who want to maximize their tax benefits and increase their cash flow. By reclassifying certain assets for depreciation purposes, property owners can accelerate depreciation deductions and reduce their tax liabilities. However, cost segregation is not without its drawbacks, and property owners should ensure that they work with a reputable firm that follows IRS guidelines. If you’re considering cost segregation for your real estate investment portfolio, consult with a qualified tax professional to determine whether it’s right for you.
