Cost segregation separates the non-depreciable personal property from depreciable real property and assigns these items to different tax classifications.
The purpose of cost segregation is to accelerate depreciation deductions on personal property items commonly found in real estate owned by businesses and investors. This accelerated depreciation can save taxpayers significant amounts of money in taxes over the life of their properties.
Cost segregation can be used for residential or commercial properties; however, commercial properties tend to be more favorable because of the larger amounts of non-depreciable personal property found in these types of facilities.
What Is Cost Segregation?
Cost segregation is a tax strategy used by real estate investors to accelerate the depreciation of their property. This strategy involves identifying and separating the various components of a property, such as the land, building, and personal property, and assigning each component a different useful life for depreciation. Using cost segregation, real estate investors can take larger depreciation deductions in the early years of their investment, which can help reduce their tax liability and increase their cash flow. Cost segregation is a complex area of tax law, and it is always best to consult with a tax professional or a qualified cost segregation specialist before implementing this strategy.
How does Cost Segregation Work?
Identify the various components of the property: The first step in a cost segregation study is to identify and inventory all of the components of the property, including the land, land improvements, and personal property. This may require a detailed inspection of the property and a review of any construction or renovation plans.
Determine the useful life of each component: The next step is to determine the useful life of each component. This is typically done using the Internal Revenue Service’s (IRS) depreciation guidelines, which provide standard useful lives for various property types. The useful life of each component determines how long the component can be depreciated for tax purposes.
Calculate the depreciation deductions: Once the useful life of each component has been determined, the next step is to calculate the depreciation deductions for each component. This is typically done using the straight-line method, which assumes that the component’s value will decline evenly over its useful life. The total amount of the depreciation deductions can then be used to reduce the investor’s tax liability.
Review and update the cost segregation study: A cost segregation study should be reviewed and updated periodically, as the components of the property may change over time. For example, if a component is replaced or removed, the useful life and depreciation deductions may need to be adjusted. Therefore, keeping accurate records and documentation of all changes to the property and its components is important.
Why is Cost Segregation Used in Real Estate Investing?
Cost segregation is used in real estate investing to accelerate the depreciation of a property. Real estate investors can take larger depreciation deductions in the early years of their investment by identifying and separating the various components of a property and assigning each component a different useful life for the purposes of depreciation. This can help to reduce their tax liability and increase their cash flow. Cost segregation is particularly useful for investors in commercial properties, which often have a large number of components that can be depreciated over a longer period.
The key to cost segregation is understanding which building components are depreciable and which ones are not. The IRS has specific rules related to the classification of assets in a building and will disallow any reclassification that does not follow these regulations. When properly implemented, cost segregation delivers a significant tax advantage for investors compared to ordinary depreciation methods.
Related: 5 Real Estate Investment Tax Strategies That Can Protect You From Inflation
What are the Benefits of Cost Segregation?
The main benefit of cost segregation is that it allows real estate investors to take larger depreciation deductions in the early years of their investment. This can help to reduce their tax liability and increase their cash flow. In addition, cost segregation can also provide other benefits, such as:
- Improved Cash Flow: By taking larger depreciation deductions, investors can increase their cash flow and have more money available to reinvest or use for other purposes.
- Enhanced Return On Investment: By reducing their tax liability, investors can increase their net return on investment.
- Enhanced Value of the Property: By identifying and separating the various components of a property, investors can gain a better understanding of the value of each component, which can help them make more informed decisions about the property and potentially increase its value.
- Accelerated Depreciation: Cost segregation accelerates the depreciation timeline for a building from 27.5 years to 15 years. You can deduct 20% of the building’s cost in your first year.
It is important to note that the specific benefits of cost segregation will vary depending on the individual investor and their particular investment situation.
The Bottom Line
Cost segregation studies can provide an immediate tax benefit and increased depreciation within your real estate portfolio. In addition, in the event of a sale, you could generate cash from some of these improvements. First, however, you will need to know how to prepare these studies and then the necessary documentation required to allow your tax preparer to claim this tax break on your behalf. So let us arrange a consultation with our industry expert today!
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