In the US, property depreciation is one of the biggest and most important deductions for landlords and buy/hold real estate investors for the reason that it reduces taxable income but not cash flow. Because of this, depreciation is often regarded as the “Phantom expense” since this is an imaginary or paper expense, in that you’re not paying for it out of pocket, the more you claim in depreciation the more you can walk away with after taxes.
There is a strategy called Cost Segregation that is used by real estate investors which provides them tremendous tax benefits
from accelerated depreciation deductions and easier write-offs when an asset becomes obsolete, broken, or destroyed.
Cost Segregation is also used to increase cash flow, and reduce the federal and state income taxes they pay on their rental income.
How it works
This is accomplished by dissecting and reclassifying certain interior and exterior building components, which are typically depreciated over 39 or 27.5 years for commercial and residential properties, respectively, to 4 categories which are personal property, land improvements, the building, and the land itself that are depreciated over 5, 7, or 15 years. Certain electrical outlets dedicated to equipment such as appliances or computers, for example, should be depreciated over a 5-year period.
All of this is taken care of in a cost segregation study. These studies are frequently carried out by a group of qualified engineers and/or CPAs.
Here’s how cost segregation works:
Example:
Scenario A
Monica, who is in the 24% tax bracket, spends USD 1,000,000 on a 24-unit apartment building, puts it into operation in 2018, and does not do a cost segregation analysis.
Her CPA determines the following:
The building is then depreciated over 27.5 years, allowing her to claim an annual depreciation expense of USD 29,090.91.
Her income and expenses were as follows:
Monica will be responsible for paying taxes on the USD 90,909.09 she earned from the property. Depreciation, on the other hand, lowered Monica’s tax burden by USD 6,981.82, and because depreciation is a non-cash item, Monica will still have USD 29,090.91 in cash.
Amazing right? Now, wait as things start to be incredible from here.
Scenario B
Supposed Monica has opted to have a cost segregation study done on her property.
According to the study, the property’s value is split down as follows:
Monica can receive 100 % bonus depreciation on the 5-year property and land improvements in the first year thanks to the Tax Cuts and Jobs Act.
The structure is still depreciated over 27.5 years, resulting in a USD13,090 annual depreciation deduction.
This provides her with a total depreciation deduction of USD 453,090 in the first year.
Let’s see how this affects her earnings this time around:
Monica will lose USD 333,090 in the first year, as you can see. That means she won’t have to pay any federal or state taxes on her net income of USD 120,000. That’s a tax savings of USD 28,800 (USD 120,000 x 24%)!
Furthermore, the remaining loss of USD 333,090 will be carried forward and used to offset income in future years.
How much more awesome is that?
The extra cash flow might be distributed to Monica or her investors directly. It can also be kept for improvements and renovations that would boost the property’s value, or it can be used as a down payment on more properties.
Is Cost Segregation the Best Option?
Cost segregation comes with its benefits and drawbacks but the benefits overwhelmingly outweigh its drawbacks. The value of front-loaded depreciation deductions, write-offs of building components that need replacement, and lower local realty-transfer taxes are all advantages of cost segregation. On the other hand, the cost of Engineering study, as well as the triggering of depreciation recapture and understatement penalties for taxpayers who utilize cost segregation too aggressively, are all disadvantages.
There is a cost involved with having a study done, and the net benefit (or lack thereof) will depend largely on the property you own as well as other tax considerations.
Cost segregation can be beneficial to any property. Owners of larger multifamily or commercial properties, on the other hand, will gain the most from these studies and should strongly consider conducting one.
You should consult your tax professional as to whether a cost segregation study is good for you.
All you need is a skilled tax professional to guide you through the procedure and help you decide if it’s the appropriate fit for your property.
We are here to help if you have questions on Cost Segregation feel free to contact IDM Professional Corporation CPA.
