Understanding Cost Segregation In Real Estate

If you invest in property or have plans to invest, understanding cost segregation in real estate could benefit your tax strategy.

Buying real estate is expensive, and so is renovating a home, store, restaurant, or warehouse. Fortunately, real estate investors can turn to a federal tax planning tool that can help them boost their cash flows when purchasing, building, or renovating residential or commercial real estate. Cost segregation can give you the financial relief you need to make it possible for you to invest in or build real estate, even with the high costs of doing so.

What Is a Cost Segregation Study?

For income tax purposes, property owners and real estate investors generally depreciate residential rental property over 27.5 years and commercial property over 39 years.

But a residence, office building, warehouse, or any other real property is never just the structure alone. It also includes several other elements, such as plumbing fixtures, carpeting, sidewalks, fencing, and a lot more.

If you were to purchase these assets by themselves, you could depreciate them over five, seven, or 15 years. But they are usually purchased as part of a building acquisition or development and written off over the same useful life as the rest of the building: 27.5 or 39 years.

A cost segregation study is a process that looks at each element of a property, splits them into different categories, and allows you to benefit from an accelerated depreciation timeline for some of those building components.

Cost Segregation Analysis Example

Say you own a warehouse that is valued at $800,000. If you were to follow the standard formula of depreciating your warehouse for 39 years, your total depreciation write-off each year would be $20,512. If you are taxed at a 37% federal income tax rate, you would save about $4,600 on your taxes each year that you own your property during this 39-year depreciation period.

Now, let’s say you decide to get a cost segregation study. After completing the study, your advisory team identifies the following costs:

  • $100,000 of interior fixtures and finishes that can be depreciated over five years
  • $100,000 of interior fixtures that can be depreciated over seven years
  • $100,000 of land improvements that can be depreciated over 15 years

This now means that your building is worth $500,000 while the systems eligible for accelerated depreciation are worth $300,000. 100% of the cost could be written off in 2021.

Assuming a 37% tax rate, that would result in tax savings of $108,153 over depreciating the building with no cost segregation (($312,820.51 – $20,512.82) x 37%).

However, even if you didn’t take advantage of bonus depreciation, those items could be depreciated over a shorter recovery period using an accelerated depreciation method. As a result, your estimated first-year depreciation write-off would be:

  • Building ($500,000 / 39 years): $12,820.51
  • 5-year property ($100,000 / 5 years): $20,000
  • 7-year property ($100,000 / 7 years): $14,285.71
  • 15-year property ($100,000 / 15 years): $5,000

Total first-year depreciation expense: $52,106.23

So even if you didn’t take advantage of bonus depreciation, your first-year depreciation write-off would result in a tax savings of $11,689.56 over depreciating the building over 39 years with no cost segregation (($52,106.23 – $20,512.82) x 37%). You can only perform a cost segregation one time on any investment property that you own.

Why Does a Cost Segregation Study Matter for Property Owners?

Segregating the costs of a property matters because of the financial benefits it provides. While the study has an up-front cost, the tax savings from accelerating depreciation deductions can result in significantly increased cash flow over several years.

With a cost segregation study, you get the benefits of time value of money. However, that also means that if you don’t plan on holding the property for the long term, you may not get any benefit from having a cost segregation study because any up-front benefits reverse upon the sale of the property.

Who will benefit from a Cost Segregation Study?

A cost segregation study makes sense if you have purchased or built investment real estate during the past 15 years. You can take advantage of cost segregation strategies whether your investment properties are residential or commercial, so owning a single-family rental would not disqualify you from the benefits of a study.

Cost segregation isn’t always the right move for investors, but it can help when investors want access to more cash to fund another investment. Maybe you already own a single-family home that you rent out. You might want to purchase an office building to add to your real estate portfolio. By cost-segregating the depreciation of your single-family property, you’ll reduce the taxes you pay on that property in the following years, freeing up additional funds that you can use to help purchase that office property.

When Should Cost Segregation Studies Be Conducted?