One of the major benefits of real estate investment are the advantages of deductions allowed by the IRS. What if it were possible to super charge these deductions? What if you could substantially increase your cash flow? If you are a real estate investor, this tax saving idea may very well make your year and many to follow.
This tax saving idea is one of the hidden gems that actually has been around for a long time. Imagine if you were able to speed up the deductions allowed by the IRS. This is exactly what the concept of cost segregation does. It is simply a way to get faster write-offs.
Let’s take a look at how this works.
The easiest way to visualize how cost segregation works is to imagine merging the talents of both your CPA and your architectural engineer.
The idea is basically to do a detailed engineering review of your investment property and look at each and every component of the structure and then determine the maximum deduction allowable by the IRS for that component. Every last screw, nut and washer is analyzed and identified as to its final intended use, how the property is affixed to the building, whether it’s designed to remain in place permanently, and how difficult it would be to move or remove.
To get a better understanding of how the tax deductions work we first need to review the traditional depreciation regarding real estate.
- Buildings – 27.5 years for residential property and 39 years for commercial property using the straight line method. This includes buildings as well as structural components, such as walls, concrete floors, paint, windows, ceilings and HVAC systems
- Land – this is not depreciable (no write-off is allowed)
- Land Improvements -15 years using 150% of the straight-line rate on the declining balance
- Personal Property – 5 or 7 years (depending on the type of property) using 200% of the straight-line rate
If you are already thinking to allocate and add as much as possible to personal property, you are right on target. As an example, if $400,000 of assets were reclassified as 7-year vs. 39-year property, depreciation deductions in the first year, assuming the building was placed in service about mid year, would increase from around $5,000 to more than $57,000.
Typical structural components that are often identified for faster write-offs include:
- Building components – plumbing, wiring, and heating and air conditioning vents and lines if they’re specifically required for equipment that has a shorter life (such as wiring for computers or equipment). You can also depreciate the allocated portion of architectural and engineering fees.
- Land Improvements – include parking lots, sidewalks, fences and landscaping
- Personal Property – includes decorative fixtures, cabinets and shelves, movable wall partitions and carpeting.
Now that you understand what a cost segregation study is I can already anticipate your next questions. How can I use it and what does it cost?
First, this must be investment property and not your residence. If can be commercial or a residential rental property. It works not only for new construction but also for remodeling expenses if they are substantial enough.
The cost varies by the complexity of the project. It is an expensive endeavor. However, the payback and return on your investment are enormous in comparison.
There are some final tax points to consider. On the downside the benefits may be limited due to the alternative minimum tax and passive activity rules. The flip side of this is that a cost segregation study qualifies for an automatic change in accounting method. This means that in the year that the cost segregation study is completed you are able to claim all of the accelerated deductions that you missed in prior years.
Utilizing a cost segregation study results in HUGE tax savings and accelerated cash flow for your real estate investments. If you have any questions about this or think this could apply to you, please do not hesitate to contact us.
Adopted from: Paul Labiner Tax & Estate Planning Perspectives 6/9/16