Purchasing real estate, as well as renovating a home, store, restaurant, or warehouse, can be quite expensive. Fortunately, real estate investors have access to a federal tax planning strategy that can help enhance cash flow when buying, building, or renovating residential or commercial properties.
Cost segregation offers financial relief by enabling investors to optimize their cash flow despite the high costs of real estate. For accredited investors aiming to maximize their after-tax returns, particularly through platforms like EquityMultiple, understanding cost segregation is essential. When applied correctly, this tactic can significantly boost the profitability of a real estate investment.
This article explores the concept of cost segregation and highlights what passive real estate investors should know.
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What Is Cost Segregation in Real Estate?
Cost segregation is a strategic tool that allows commercial real estate investors to accelerate depreciation deductions on certain components of their properties.
Instead of depreciating the entire property over the standard 27.5 or 39-year period, cost segregation enables you to break down the property into shorter-lived assets, such as personal property, land improvements, and specific building components. This approach offers several key benefits:
- Reduced Tax Liability: By front-loading depreciation on assets with shorter life spans, you can significantly lower your taxable income in the early years of ownership, leading to substantial tax savings.
- Enhanced Return on Investment (ROI): Cost segregation can accelerate your ROI by improving the overall financial performance of your commercial real estate investment.
For real estate investors, particularly those involved in large-scale commercial projects, understanding and using cost segregation can yield significant tax advantages.
By accelerating depreciation expenses, investors can defer federal and state income taxes, thus enhancing the property’s cash flow during the early stages of the investment.
Individual investors might also leverage cost segregation by investing fractionally alongside a sponsor who operates on a large scale. (As always, it's advisable to consult with a professional tax advisor when considering real estate investments.)
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How Does A Cost Segregation Study Work?
To benefit from cost segregation, the first step is to conduct a cost segregation study. This study helps you maximize tax deductions on your investment property. It’s advisable to hire a financial firm with expertise in engineering, construction, tax law, and accounting to carry out the study.
It’s important to note that cost segregation can only be performed once on any given investment property.
1. Complete A Feasibility Analysis
The initial step is for your cost segregation team to analyze your investment property to ensure it’s suitable for the process. This involves examining various components of the property, such as:
- Plumbing fixtures
- Roofing
- Electrical systems
- Sidewalks
- Driveway
- Flooring
- Other materials
The rationale here’s that if these components were purchased separately, they could be depreciated over 5 to 15 years under the IRS tax code. However, if they’re part of a purchased building, the depreciation period extends to 27.5 years for residential buildings or 39 years for commercial properties.
A cost segregation study allows each component to be reclassified, enabling accelerated depreciation.
2. Gather All Necessary Information
The professionals conducting your cost segregation study will need various documents to assess the value of your property and its systems. This could include a recent property appraisal, inspection reports, and the closing documents from when you purchased the real estate.
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3. Analyze The Property
The next step involves identifying any operating costs of your property that can be depreciated over 5, 7, or 15 years. This is done by reviewing documents such as blueprints, property records, and inspection reports.
4. Complete A Report
After analyzing the property, your team will prepare a report detailing how much you can save on income taxes by applying cost segregation strategies.
Cost Segregation Analysis Example
Let’s say you own a warehouse valued at $800,000. If you use the standard method of depreciating the warehouse over 39 years, your annual depreciation write-off would be $20,512. At a federal income tax rate of 37%, this would save you about $4,600 on your taxes each year during the 39-year depreciation period.
However, if you conduct a cost segregation study, your team might identify the following:
- $100,000 in plumbing fixtures that can be depreciated over 5 years
- $100,000 in electrical fixtures that can be depreciated over 7 years
- $100,000 spent on curbs, sidewalks, and storm sewers that can be depreciated over 15 years
This means the building’s value for standard depreciation is now $500,000, while the components eligible for accelerated depreciation total $300,000.
Using The Information From A Cost Segregation Study
With this information, you can claim more depreciation on your taxes in the early years. For example, in the first year after completing your cost segregation study, you could write off approximately $12,820 in depreciation costs for the building:
- $20,000 for the plumbing fixtures depreciated over 5 years
- Around $14,285 for the electrical fixtures depreciated over 7 years
- $5,000 for the exterior improvements depreciated over 15 years
Assuming a 37% tax rate, this would result in a first-year tax savings of about $11,689, a significant increase over the $4,600 in savings you’d get without a cost segregation analysis.
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Who Will Benefit From A Cost Segregation Study?
A cost segregation study is beneficial if you’ve purchased or built investment real estate in the past 15 years. Both residential and commercial property owners can take advantage of cost segregation, so even owning a single-family rental home doesn’t disqualify you from the benefits.
Cost segregation might not always be the best option, but it’s useful when investors need more cash flow to fund additional investments.
For example, if you already own a rental home and want to purchase an office building, cost-segregating the depreciation of your rental property could reduce your taxes, freeing up funds to help with the office building purchase.
When Should Cost Segregation Studies Be Conducted?
You can order a cost segregation study any time after buying, building, or remodeling a property. However, the ideal time is before filing your tax return for the year you made the purchase, build, or remodel.
This timing maximizes your tax savings when your real estate expenses are likely at their highest.
Look-Back Studies
What if you didn’t perform a cost segregation study when you first bought, built, or remodeled the property? You can still benefit from this strategy by ordering a look-back study.
A look-back study allows you to claim a catch-up tax deduction. Once the study is complete, you can claim this deduction in a single year, equal to the difference between what you originally claimed as depreciation and what you could have claimed had you done the study earlier.
According to IRS rules, you can perform a look-back study on properties purchased, built, or remodeled as far back as January 1, 1987.
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How Long Does a Cost Segregation Study Take?
Tax and engineering professionals consider various factors when conducting a cost segregation study, which typically takes at least a month to complete.
The exact duration depends on the type and size of your property, as well as your ability to provide the necessary documentation to the analysts. On average, you can expect a cost segregation study to take between 30 to 60 days.
Best Cost Segregation Companies
Remote Cost Seg
Remote Cost Seg is recognized as the top cost segregation company overall, thanks to its combination of cutting-edge technology, expert team, and personalized service. They use proprietary software and 3D modeling to deliver accurate cost segregation analyses, ensuring significant tax savings for their clients.
The company is known for its competitive pricing, detailed reporting, and strong client education resources, making it an excellent choice for property owners looking to maximize their tax benefits. Their focus on high ROI and tailored services sets them apart in the industry.
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Omega Accounting Solutions
With 15 years of tax experience, Omega Accounting Solutions offers a range of services related to tax credits and incentives, helping you maximize your next tax return. From cost segregation to Employee Retention Credits (ERC), Omega provides free consultations and secure, streamlined processes for claiming deductions and credits.
In addition to cost segregation, Omega offers various other business and financial services, which you won’t typically find with other cost segregation companies. The positive reviews from satisfied clients highlight Omega’s effectiveness in these areas.
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KBKG
KBKG stands out for its wealth of resources, including free tax calculators, tax software, and a wide array of tax credit services backed by years of industry experience. These factors make KBKG one of the top choices for cost segregation.
The company is known for excellent customer support and has garnered a solid number of online reviews, which is uncommon in the cost segregation industry. The overwhelmingly positive feedback praises KBKG for its professionalism, responsiveness, and the quality and timeliness of its cost segregation studies.
Cost Segregation FAQs
What Do Cost Segregation Studies Include?
In a cost segregation study, a team of tax and engineering experts examines various building components, such as wiring, plumbing, light fixtures, flooring, and exterior improvements to determine whether you can accelerate the depreciation of some of them.
How Will I Pay for a Cost Segregation Study?
The cost of a study varies depending on the size and type of your property but ranges from $5,000 to $15,000.
Can I Do a Cost Segregation Study on My Own?
While you can technically perform a cost segregation study yourself, it’s not recommended. To maximize your tax savings, it’s best to rely on engineering and tax experts.
Is Cost Segregation Worth It?
Despite the high fees associated with a cost segregation study, it’s typically a smart financial move. The tax savings you gain each year after the study usually far exceed the one-time fee.
Can I Do a Cost Segregation Study on My Primary Residence?
No, cost segregation isn’t available for primary residences. It can be used on residential real estate, but only for properties you own as investments, not those you live in full-time.
The Bottom Line On Cost Segregation
Cost segregation is a powerful tax planning tool that allows real estate investors to accelerate the depreciation of their investment properties.
By doing so, they can significantly reduce their annual federal and state income tax payments, potentially freeing up capital for other investments or purchases.
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