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In the world of real estate investment, achieving maximum returns and optimizing cash flow are top priorities. Yet many real estate owners, investors, and their tax advisors overlook cost segregation studies.
That’s a missed opportunity for your real estate clients because cost segregation studies can significantly improve the profitability and reduce the tax burden of their non-residential and residential rental properties.
A cost segregation study can also help defer federal and state income taxes owed on those investments.
What is a cost segregation study?
A cost segregation study examines each element of a property, splits those elements into different categories, and allows the owner to benefit from an accelerated depreciation timeline for some of those building components. While a cost segregation study has an up-front cost, the tax savings from accelerating depreciation deductions can significantly increase cash flow over several years.
In more detail, let’s explore the benefits of conducting a cost segregation study.
Five Key Considerations
1. Accelerated Depreciation
One significant advantage of conducting a cost seg study is the opportunity to speed up depreciation deductions.
Typically, the depreciation of non-residential property is spread over 39 years, and 27.5 years for residential rental properties. A cost segregation study, however, allows for the reclassification of certain parts of a property — such as personal property, land improvements, and specific building elements — to shorter depreciable lifespans of typically five, seven, or fifteen years.
It’s important to remember that land itself cannot be depreciated.
Conducting a cost segregation study generally requires specialized engineering, construction, and tax law knowledge. By accelerating depreciation, your real estate clients can significantly increase tax deductions earlier in the investment period. Doing so lowers their taxable income and enhances their cash flow.
Cost segregation becomes particularly potent when combined with bonus depreciation. This tax incentive permits businesses to deduct a substantial portion of the purchase price of eligible business assets in the year they are placed in service.
According to the Tax Cuts and Jobs Act of 2017, bonus depreciation was temporarily raised to 100% for qualifying assets placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Starting in 2023, however, this bonus rate was reduced by 20% and will continue to be reduced by 20% annually until it is phased out entirely by the end of 2026.
Eligible assets for bonus depreciation are generally those under the Modified Accelerated Cost Recovery System (MACRS) with a recovery period of 20 years or less, including 15-year Qualified Improvement Property.
2. Property and Transaction Type
Cost segregation studies are suitable for any property type, whether commercial or residential rental, with both categories being excellent candidates.
Properties in which the purchase price or improvement costs create a depreciable basis exceeding $500,000 are ideal for cost seg studies. The general breakdown of applicable property and transaction types includes:
- Commercial properties: This category encompasses structures such as office buildings, shopping centers, hotels, resorts, restaurants, golf courses, light and heavy manufacturing facilities, wineries, auto dealerships, distribution centers, and warehouses.
- Residential rental properties: This includes multi-family housing units, apartment complexes and both short-term and long-term rentals.
- Transaction types: Applicable transactions include recently purchased properties, newly constructed buildings, properties that have undergone significant renovations or expansions, and properties with a stepped-up basis, typically due to inheritance or other transfers.
3. Optimal Timing for a Study
The ideal timing for a cost segregation study can vary depending on individual tax circumstances. Performing the study during or immediately after a property’s construction or acquisition can lead to the immediate benefit of accelerated depreciation deductions.
Similarly, conducting the study following significant renovations or expansions is advantageous as it helps identify components that qualify for quicker depreciation.
Cost segregation studies can also be conducted retroactively for properties that have been operational for years. This allows property owners to claim missed depreciation by adjusting their accounting methods — often resulting in substantial one-time deductions.
Coordinating the timing of a cost segregation study with broader tax planning strategies is beneficial for your clients, especially in years when they expect higher income. Accelerating depreciation can help mitigate this income and reduce their tax liabilities.
4. Increased Cash Flow
As mentioned earlier, a cost segregation study accelerates depreciation deductions, enabling investors to realize tax savings much earlier than the typical depreciation schedule would allow. This boosts current cash flow, which can then be reinvested back into the property for upgrades, expansions, or other projects that add value.
Additionally, if conducted at an opportune time, a cost segregation study can facilitate your client’s ability to claim a disposition loss for assets that are no longer in service or are being upgraded.
5. Compliance and Audit Support
Cost segregation studies conducted by qualified professionals adhere to IRS guidelines and methodologies, ensuring compliance with tax regulations.
In the event of an IRS audit, the detailed documentation and analysis provided by a cost segregation study will serve as valuable evidence to substantiate depreciation deductions, minimizing the risk of disputes and penalties.
The Benefits of Cost Segregation
The benefits of a cost segregation study are undeniable for real estate investors seeking to optimize tax efficiency, increase cash flow, and maximize returns on investment.
By leveraging accelerated depreciation, enhancing cash flow, and gaining insights into asset valuation, your real estate clients can unlock the full potential of their commercial properties.
As the real estate market evolves, cost segregation is an effective strategy for enhancing profitability and ensuring sustained success in an inflationary environment.
In conclusion, the strategic advantages of cost segregation studies cannot be overstated for real estate investors aiming to enhance their profitability and optimize cash flow. By accelerating depreciation and unlocking significant tax savings, these studies provide a powerful tool for maximizing returns on investment. As the real estate landscape continues to change, taking advantage of this opportunity becomes increasingly critical. Don’t let your clients miss out on the potential benefits. Contact Tri-Merit today to learn more about how a cost segregation study can transform their real estate investments and elevate their financial strategies.
