Cost Segregation & Commercial Real Estate
Real estate has been a standard investment vehicle for many of the wealthiest individuals in history. This is due, in part, to the extensive tax benefits that owning real estate affords investors.
Depreciation is one of the primary means to obtain these tax benefits. Savvy investors know that the depreciation allowed on a commercial property can offset gains, greatly decreasing or even eliminating tax burdens.
What is depreciation?
Depreciation is the decline in the value of an asset over time. This depreciation decreases an investor’s tax liability. An asset is considered depreciable when it has a useful life of one year or more.
In business, a variety of assets can be depreciated – computers, machinery, technology, etc. The IRS allows depreciation in varying degrees based upon pre-determined lifespan assumptions of the asset in question. Instead of deducting the entire value of a purchased asset all at once, the taxpayer is permitted to spread that deduction out over the time allotted.
In real estate, buildings are given a depreciation lifecycle of 27 ½ years for residential buildings and 39 years for commercial buildings.
This means that an investor purchasing a commercial building for $1,000,000 would spread the depreciation (tax deduction) of that property over 39 years, deducting $25,641 per year from taxable income.
What is cost segregation?
Cost segregation allows real estate owners to utilize accelerated depreciation deductions, thereby increasing cash flow while simultaneously decreasing the taxes paid on their rental income.
This is possible by segregating various aspects of a building’s interior and exterior properties into its depreciable categories. As mentioned before, the IRS has determined that assets have varying lifespans, and thus varying depreciation timelines. Assets considered personal property such as furniture, fixtures, carpet, electrical systems, and window treatments are depreciated over 5 or 7 years. Land improvements such as landscaping, paved parking lots, and sidewalks are depreciated over 15 years.
What is a cost segregation study?
These accelerated depreciation schedules should never be implemented without a cost segregation study done by a professional cost segregation consultant or CPA. A cost segregation study analyzes the building to determine if the identification and segregation of certain components of the property for accelerated depreciation will benefit the owner. If determined beneficial, the cost segregation analysis will separate assets into four categories:
- Personal property
- Land improvements
- Buildings and/or structures
- Land
The buildings and structures will remain on the same depreciation timeline as mentioned above (27 ½ – residential, 39 – commercial). Land cannot be depreciated, as it is a resource that is never “used up”. However, both personal property and land improvements can be depreciated on an accelerated basis.
A thorough cost segregation study will include a review and evaluation of all available information related to the property. Reports, inspections, cost details for the property, and blueprints are all reviewed, along with a physical inspection of the property.
A cost segregation study provides the property owner with a written report detailing the accelerated depreciation deductions for income tax purposes.
What are the benefits of cost segregation?
Cost segregation provides a legal tax shelter for taxable income received from real estate operations. Accelerated depreciation reduces income taxes, consequently increasing profit from cash-flowing properties.
More about cost segregation studies
Not for Everyone – A cost segregation study is costly (between $10,000 – $15,000), so not all properties are prime candidates for this method. If a property is not currently cash-flowing or the tax savings that it would provide are less than the cost of the study, the analysis may not be ideal.
Timing is Important – For maximum tax benefits, a cost segregation study should be done within the first year of purchasing, remodeling, or building a commercial property.
Limited Time Provision – The Tax Cut and Jobs Act of 2017 made an additional provision for accelerated depreciation. Business owners can take a bonus depreciation of 100% for certain qualified assets within the first year of purchasing, as opposed to depreciating over a longer period of time. However, this deduction will only be available until 2022 and slowly phased out by 2027.
For more information about how a cost segregation study could decrease your tax liability, speak to one of our brokers. We work with professional cost segregation analysts that can set you up for success as you constantly optimize your tax reduction strategies.
Disclaimer: The information contained in this article is not intended to provide legal or tax advice. Please speak to a tax attorney, CPA, or financial adviser for professional guidance.