Real estate investors are increasingly using a tax strategy called cost segregation to unlock significant cash flow and accelerate depreciation deductions. This method allows property owners to reclassify parts of their buildings for faster tax write-offs, potentially saving hundreds of thousands of dollars in taxes annually.
Key Takeaways
- Cost segregation studies reclassify building components for accelerated depreciation.
- This strategy can dramatically increase first-year tax deductions.
- It often benefits high-income investors and commercial property owners.
- Studies typically cost several thousand dollars but can yield substantial tax savings.
Understanding Depreciation in Real Estate
Real estate offers many tax benefits. Property owners can deduct various expenses, including mortgage interest, insurance, and even travel costs. Among these, depreciation stands out as a powerful tool for reducing taxable income.
Standard depreciation allows investors to deduct the cost of a building over its useful life, as defined by the IRS. For residential properties, this period is 27.5 years. Commercial properties have a longer depreciation timeline of 39 years. To calculate the annual deduction, owners divide the building's value, excluding land, by the applicable number of years.
For example, a commercial building purchased for $1 million would typically allow for an annual deduction of about $25,600 (1/39 of $1 million). This traditional approach spreads the tax benefit evenly over many years.
Quick Fact
The IRS defines the useful life for residential properties at 27.5 years and commercial properties at 39 years for standard depreciation.
How Cost Segregation Accelerates Deductions
A cost segregation study, often called a "cost seg," changes the standard depreciation calculation. Instead of treating the entire building as a single asset, engineers analyze the property to identify individual components. These components are then reclassified into shorter depreciation categories.
Engineers examine both internal and external elements of a property. This includes items like flooring, electrical systems, plumbing, and HVAC units. They might determine that certain electrical outlets or specific fixtures have a useful life of five, seven, or 15 years, rather than the building's overall 39 years.
By reclassifying these shorter-life assets, investors can depreciate a significant portion of the property's cost much faster. This front-loads the deductions, providing larger tax savings in the initial years of ownership.
"You can take a big chunk in those first couple of years and basically put yourself into a loss position because the deduction is so large," explains CPA Kristel Espinosa. "If you don't need all of the loss in the current year, that loss carries over into subsequent years, so those losses could shelter the rental income from this property for years to come."
The Impact on Cash Flow
The acceleration of deductions can dramatically increase an investor's first-year write-offs. Using the $1 million commercial building example, an investor could potentially deduct hundreds of thousands of dollars upfront through accelerated and bonus depreciation, instead of just $25,600.
This reduction in taxable income directly translates into increased cash flow. Investors can then reinvest these savings into their portfolios, acquiring additional properties or improving existing ones. One investor, Jill Green, a physician who invests in real estate, has used these tax savings to expand her portfolio by about one property each year.
Important Context: Passive vs. Active Income
Generally, depreciation deductions can offset passive income, such as rental income. However, investors who qualify as real estate professionals under IRS rules can use rental losses to offset active income like W-2 wages. This makes cost segregation especially powerful for those who meet the real estate professional status (REPS) criteria, as it can significantly reduce their overall tax liability.
When a Cost Segregation Study Makes Sense
A cost segregation study typically costs several thousand dollars and takes one to two months to complete. The decision to undertake one depends on several factors, including the property's size, purchase price, and the investor's individual tax situation.
CPA Kristel Espinosa notes that the strategy generally works best for higher-income investors and those who own commercial properties or large portfolios. She estimates that a cost segregation study typically allows 20% to 40% of a building's cost to be reclassified into shorter depreciation periods.
This reclassification can generate substantial first-year tax savings. For every $1 million in building cost, investors could see $50,000 to $150,000 or more in tax savings, depending on the study's results and their tax situation. For a $15 million commercial building, reclassifying $5 million into shorter-life assets could lead to $3 million in deductions. At a 37% federal tax rate, this could result in approximately $1.11 million in federal tax savings alone.
- Property Type: Commercial buildings often benefit more due to a greater number of components available for reclassification.
- Purchase Price: Higher purchase prices generally yield larger potential savings, making the study's cost more justifiable.
- Investor Income: Higher-income investors in top tax brackets stand to gain the most from significant deductions.
While powerful, cost segregation studies are not suitable for every property. For example, for a smaller property purchased for $123,000, especially if the investor plans a quick sale, the cost of the study might outweigh the benefits. Investors should always consult with experienced CPAs and cost segregation specialists to determine if the strategy aligns with their financial goals. Retaining detailed engineering reports is also crucial in case of an audit.
