Cost segregation is a tax-saving tactic that segments certain components of improved property you own by “class” or type of component. This segmentation maximizes your ability to accelerate depreciation deductions against taxable income. This valuable tax planning method should be investigated by every taxpayer who owns investment and commercial real estate.
In brief, cost segregation allows a property owner to lawfully re-characterize the depreciation taken on certain components of his or her building as personal property and land improvements instead of structural components of the building. Doing this accelerates that portion of the depreciation to five, seven or 15 years instead of the usual straight-line periods of 27.5 years for single and multi-family type properties and 39 years for commercial buildings. In addition, recent federal tax law changes have increased the value these benefits can provide.
This simple additional asset appraisal step can dramatically improve the near-term benefit of owning the property, offering a reduction in current tax liability. This unlocks instant tax benefits that can be used to offset taxable gain on other properties being sold; or, it can give the property owner increased tax-free cash flow.
And cost segregation is applicable to a wide range of commercial and rental properties, such as:
- Apartment buildings
- Single-family rentals
- Retail Space of all types, including shopping centers, restaurants and car dealerships
- Office buildings
- High-tech facilities
- Low-tech manufacturing facilities
- Medical buildings
How much could you save?
Cost segregation experts with whom I work use the following examples as typical of the tax benefits they have seen property owners gain:
- Tax savings could equal 20 cents for each dollar that is reclassified. So, a property valued at $5,000,000 could return upfront cash flow benefits of $200,000 if 20 percent of the costs are reclassified.
- Between 15 and 40 percent of a building’s overall costs can be reclassified to a shorter recovery period in typical commercial properties
Applying this practically to specific situations, here are just two of many examples I can cite of the powerful impact this tax law provides:
- A retired property owner with a large real estate portfolio of apartment buildings and commercial properties, has an annual taxable income of $2.5 million and pays $500,000 in state and federal income taxes each year. Cost Segregation benefits available to him on a small commercial building and an apartment complex he had built provided $3.4 million in accelerated depreciation benefits the first year, saving the property owner $1,506,000 in taxes over a three-year period (same as tax-free increased income).
- An office building was purchased for $10 million providing $2,564,100 in straight-line depreciation benefit over the 10 years it has been owned. Cost Segregation captured for the owner first year benefit of an additional $1,358,970 in accelerated depreciation. This provided him a first year tax-free increase in income of $475,640.
How do you get this done?
The IRS requires a cost segregation study be performed by qualified experts in this area of law to validate the tax benefits per the IRS regulations. I recommend working with firms that have multiple years of experience under their belts. Further, they should be able to demonstrate a solid history, the commitment to deal with the IRS at their own expense if the IRS challenges their work, and a success in passing IRS audits. The cost segregation specialists I work with all comply with these standards and offer decades of experience. If you need a referral, let me know.
Keep your eye on the bigger prize
Cost segregation is a highly valuable tax-saving tool, but it is just one plank in your overall strategic tax plan. Your first step is always to work with a proactive tax planning advisor to identify missed opportunities and wasted taxes you have unknowingly paid; pinpoint the amount of taxes that tax law says you are entitled to keep; and develop an all-encompassing plan for you to capture those benefits, which includes your real estate portfolio. Get this overarching plan in place first, then pull the trigger on the more tactical steps like cost segregation.