As a real estate investor and developer, I have learned that every dollar counts. Development budgets are tight and the returns on any deal are impacted by every decision. One often overlooked is the potential tax savings and planning opportunities available for a transaction. There is no better tax-saving opportunity for an investor than a Cost Segregation Study. Most investors do not fully understand the benefits of a Cost Segregation Study, and it’s amazing how few tax professionals are aware of this opportunity.
A Cost Segregation Study is a review of the type of assets found in a building or real estate structure being built, renovated, or purchased. What a Cost Segregation Study helps evaluate is how much depreciation is allowed to be taken each year on a building or real estate investment. Historically, if you purchased or built a building, the cost of the building was depreciated over 27.5 years for residential investments or 39 years for commercial investments. However, personal property (furniture, fixtures, machinery, equipment, etc.) in a building can be depreciated over a much shorter time frame – either 5 or 15 years. A Cost Segregation Study analyzes how much of a building can be allocated to these shorter year depreciation assets, which depreciates the cost of your investment faster to increase the tax savings in early years. A Cost Segregation Study does not change the amount of depreciation taken over the life of the asset, but it creates a significant time value of money savings. The Tax Cuts & Jobs Act of 2017 increased bonus depreciation to 100% and allows for up to $1m of immediate expensing of new roofs, HVAC, Security Systems, and other asset purchases. Investors need to take advantage of these huge tax benefits and a cost segregation study is paramount to taking the most depreciation possible in early years.
The biggest question we receive is “How much money can I save by doing a cost segregation study?” While each case depends on the facts and circumstances of the asset purchased, taxpayers should see significant time value of money savings. Some taxpayers might even generate a loss as a result of the large amounts of first-year depreciation created through a cost segregation study. Generating losses is a great thing to do. Why would a taxpayer want to create a loss? The recently passed CARES ACT, part of the government’s efforts to combat COVID-19, allows taxpayers to carry losses back 5 years and file amended returns. These amended returns in the recoupment of taxes previously paid. A cost segregation study can help generate losses that put money back in your pocket.
Example: Let’s say you purchase a multi-family apartment complex and the value of the buildings (not the land, which isn’t depreciated) is $2 Million. Traditionally, this would have a depreciable life of 27.5 years for tax purposes. A simple analysis would say the taxpayer is entitled to around $72k of depreciation each year which would generate a tax benefit of roughly $17k per year (assuming a 23.8% rate). However, in a cost segregation study, a general rule of thumb is that 25% of the multi-family building value can be reclassified as assets with a shorter depreciation period.
So, that means that $500,000 of the $2 Million purchase price can be classified as 5 or 15-year property. Under the Tax Reform Act, 5 or 15 year property is subject to expanded 100% Bonus Depreciation, meaning taxpayers can deduct the cost of these assets in the year of purchase (depending on the amount). Because of this, the taxpayer could write off the $500,000 of 5 & 15 year assets in year one. Combined with the additional depreciation that is spread over 27.5 years, a cost segregation study in our example leads to $555,000 of first year depreciation deductions, which is a tax benefit of around $550,000 (using a 37% rate). In our example, the cost segregation study generated over $178,000 of additional, year one tax benefit. An accurate cost segregation study all but guarantees that taxpayers can take more depreciation in the early years of the investment, which generates more tax savings and benefits.
Unfortunately, you cannot do a Cost Segregation Study on your own. It usually requires a team of experts to review blueprints, invoices, and the site to develop the cost allocations. When I evaluate a real estate asset, I immediately begin to consider the benefits of a Cost Segregation Study. I’ve personally experienced tremendous savings and want to help others see the same benefits. If you are a Real Estate Investor or Professional, contact me and I would be happy to refer you to the professionals who have tremendously helped me so far!
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