Real Estate Cost Segregation: Everything You Need to Know

Real estate is a profitable investment option that not only helps investors keep up with inflation and earn significant passive income but also provides various tax advantages to retain more earnings. Among these advantages, cost segregation is a smart tax strategy that can further increase profits. Life Bridge Capital, a prominent real estate syndication company, allows investment partners to invest in fractional ownership of multifamily rental properties to generate a steady passive income each month. For more information, visit their website.

What is Cost Segregation?

Cost segregation is a tax strategy that involves reclassifying certain types of property to increase deprecation and reduce taxable income. Depreciation is a tax mechanism that allows property owners to deduct the portion of their assets’ usable lifespan that has been used up each year. For residential properties, the lifespan used to calculate depreciation is 27.5 years, while for commercial properties, it is 39 years. However, the 2017 Tax Cuts and JOBS ACT enables the acceleration of the depreciation deduction timeline. Cost segregation can further expedite the depreciation schedule, leading to increased tax benefits.

How to Calculate Depreciation 

There are multiple methods for calculating depreciation, but the straight-line method is the most common. It yields a consistent depreciation deduction each year of the asset’s usable life. To calculate depreciation using this method, simply divide the purchase price, excluding the land value, by the allowable number of years as determined by the IRS.

Remember, total depreciation will never equal the full purchase price of a property. This is because the value of the land itself is not subject to depreciation. After all, the land is considered to last forever. So, one could depreciate the purchase price minus the land value over the 27.5 or 39-year schedule. 

Additionally, the IRS allows owners to break down the asset type further. This is where cost segregation comes in.

Using Cost Segregation to Accelerate Depreciation

Instead of putting an entire property and its assets into the 27.5 or 39-year depreciation schedule, cost segregation divides the assets into more precise categories. The Internal Revenue Service (IRS) has categorized property into four distinct types:

• Land, which cannot be expensed.

• The building depreciates over 39 or 27.5 years, depending on whether it is for commercial or residential purposes.

• Improvements are expensed over 15 years. Things like sidewalks and fences are considered improvements.

• Personal property may be expensed over 5 or 7 years.

Cost segregation aims to maximize the depreciation deduction that can be claimed immediately. For instance, instead of claiming a lump sum deduction of $727 over 27.5 years for a $20,000 furniture expense, cost segregation divides the expense into five years, allowing for a $4,000 deduction each year. This way, the depreciation deduction becomes immediately available and more substantial.

What is the Benefit of Accelerating Depreciation Using Cost Segregation?

Cost segregation is a strategy that many real estate investors pursue because it allows them to claim depreciation deductions more quickly. This is particularly useful for investors who do not plan to hold onto a property for an extended period. By depreciating assets like improvements and personal property on a lengthier timetable, investors may not use the entire depreciation deduction and leave money on the table. In contrast, cost segregation enables investors to claim the depreciation deduction sooner and in a more significant amount.

Additionally, cost segregation and accelerated depreciation can be especially advantageous if you expect to replace items before they fully depreciate. Assets like furniture and electronics often have a relatively short usable life and will need to be replaced. With cost segregation, you can claim the depreciation deduction on the replacement items, creating a new opportunity for tax savings.

A crucial benefit of cost segregation is that it reduces the tax burden, leaving more money in your pocket. For high-value properties, cost segregation can reduce taxable income by hundreds of thousands of dollars. The money saved can be immediately reinvested in your next venture.

It’s important to keep in mind that the tax code can change suddenly and without much notice. Thus, an opportunity like cost segregation may end at any time. Therefore, many investors prefer to take any available deduction immediately rather than save it for a future tax year. However, cost segregation is not always the best choice, as some owners prefer a consistent depreciation deduction each year to reduce their tax burden. If you do not plan to make significant purchases that will yield additional depreciation deductions, cost segregation may not be beneficial for you.

Final Thoughts

If you plan to use cost segregation to accelerate the depreciation of your property, it’s crucial to engage the services of a professional to create a cost-segregation study. This study is typically completed by a team of accountants, lawyers, and engineers and serves as a safety net if the IRS questions your classifications.

By conducting a cost segregation study, you can maximize your possible depreciation deduction and ensure that you are in compliance with IRS regulations. It is a valuable tool for real estate investors who want to reduce their tax burden and increase their cash flow.

At Onbridge Capital, we offer investment partners the opportunity to leverage shares of multifamily rental properties and earn a passive monthly income. We understand the importance of tax-efficient strategies like cost segregation and can help you navigate the complexities of real estate investing.