Cost Segregation: Reducing the Tax Burden of Real Estate Investments
Investors repeatedly turn to real estate, not just because of income potential, but because more of the profit stays with owners and investors thanks to a favorable tax code. The depreciation deduction is one of the big perks of real estate investing. Cost segregation maximizes that deduction, allowing investors to keep more money from a successful deal in their pockets.
Cost Segregation Accelerates Depreciation
Depreciation is a tax term that refers to the portion of a property’s lifespan consumed or used each year. All structures deteriorate over time, and that shortening of the usable life is treated as an expense that reduces the tax burden. Typically, owners calculate the lifespan of residential properties at 27.5 years and 39 years for commercial properties.
However, cost segregation allows us to reclassify various property types to accelerate the rate at which we can claim the depreciation deduction to utilize the maximum amount of depreciation at any given time.
When calculating depreciation, one option would be to divide the purchase price, minus the land value, by 27.5 or 39 years, depending on the property. Using that method, the owner deducts the same amount of depreciation each year. However, doing so often leaves money on the table. That’s where cost segregation comes in.
Cost Segregation Categories
The IRS permits owners to divide assets into four categories, each having a different lifespan for depreciation. A professional should perform a cost segregation study of the assets before you begin taking the increased deduction. The analysis classifies each portion of the property as land, buildings, improvements, or personal property.
First, the land value must be subtracted from the depreciation calculation because the land is considered to last forever.
The building itself depreciates over 39 or 27.5 years, depending on whether it is a commercial or residential building, respectively.
Improvements to the property may be expensed over 15 years. Improves include sidewalks, landscaping, fences, and other additions that enhance the property.
Finally, personal property may be expensed over 5 or 7 years. Personal property includes many of the fixtures and items in an income-producing property, including furniture and appliances.
Why Use Cost Segregation
Cost segregation appeals to investors for a few reasons. First and foremost, any opportunity to reduce the tax burden gives an investor more capital with which to make additional investments.
Cost segregation proves especially beneficial to projects like real estate syndications that only last a few years. Depreciating improvements and personal property on the standard 27.5-year timeline cause short-term owners to miss out on significant tax savings.
Additionally, the assets that qualify for the accelerated timeline have a shorter usable lifespan and may need to be replaced before it fully depreciates under the traditional timeline. Their replacements bring new opportunities for deductions.
Finally, many tax professionals recommend taking any deduction when it is available because it may not be available in future years. The tax code can change at any time, so planning to take the straight-line depreciation over decades would be a waste if cost segregation is ultimately phased out.
Takeaways for Investors
Limited partners see the benefits of cost segregation each year when the syndication sends each one a schedule K-1 detailing their share of tax deductions. Syndications that take advantage of cost segregation pass on the deduction and significantly reduce investors’ tax burdens.