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Cost Segregation: The Strategy Real Estate Investors Use to Pay Little to No Taxes On Their Investments

Posted by Thomas Castelli on Sep 6, 2018

Have you ever been caught in the middle of a conversation about how ridiculous it is that wealthy people end up paying so little in taxes?

I know I have.

I was at the Christmas dinner table last year, with a mouthful of lasagna and cheese still dripping from the fork, when my uncle starts complaining about how the tax system benefits the rich, and how unfair it is to the middle class.

That’s when I had to put my fork down, take a sip of my ice cold beer, and step in to correct him.

The fact is, anybody can benefit from tax system, if they know how to play the game. There is no secret the rich are hiding. The information is right out there in the open for anybody willing to figure out how to use it.

Luckily, you won’t have to dig through the tax code to find out about this tax “secret” that real estate investors use to pay little or no taxes on the income from their rental real estate.

It’s called Cost Segregation...

What is Cost Segregation?

Cost Segregation is a tax strategy that allows real estate owners to utilize accelerated depreciation deductions to increase cash flow, and reduce the federal and state income taxes they pay on their rental income.

This is done by breaking down and reclassifying certain interior and exterior components of a building, which are typically depreciated over 39 or 27.5 years for commercial and residential properties, respectfully, to personal property or land improvements that are depreciated over 5, 7, or 15 years.

This is all handled in what is known as a cost segregation study. These studies are often conducted by a team of qualified engineers and/or CPAs.

Benefits of Cost Segregation

As mentioned above, cost segregation can reduce taxes, and greatly increase the cash flow of a property, especially in its early years of operation.

Thanks to the Tax Cuts and Jobs Act, used personal property placed into service after 9/27/17 is eligible for 100% bonus depreciation. That means real estate investors can deduct 100% of 5, 7, and 15 year property all in the first year.

This is what makes cost segregation so powerful and can lead to significant tax savings!

Of course, the building itself will have to still be depreciated over 27.5 or 39 years, and land remains undepreciable.

Example:

Scenario A

Jane Doe, who is in the 24% tax bracket, buys a 24 unit apartment building for $1,000,000, places it into service in 2018, and does not utilize a cost segregation study.

Her CPA determines the following:

The building is then depreciated over 27.5 years, allowing her to take $29,090.91 as an annual depreciation expense.

Her income and expenses were as follows:

Jane will have to pay taxes on the $90,909.09 received from the property. However, the depreciation expense reduced her tax liability by $6,981.82, and since depreciation is a noncash expense, Jane will still have the $29,090.91 in cash.

Pretty cool right?... Just wait it gets better.

Scenario B

Now, let’s say Jane decided to have a cost segregation study performed on her property.

The study finds that the value of the property is broken down as follows:

Thanks to the Tax Cuts and Jobs Act, Jane can take 100% bonus depreciation on the 5-year property, and land improvements in the first year.

The building is still depreciated over 27.5 years, allowing for an annual depreciation deduction of $13,090.

This gives her a total depreciation deduction in year one of $453,090.

Let’s take a look at how this affects her income this time around:

As you can see, Jane will show a net loss of $333,090 in year one. That means she will not have to pay any federal or state taxes on the $120,000 of net income. That’s $28,800 ($120,000 x 24%) in tax savings!

Plus, the remaining $333,090 loss will be carried forward and offset income in future years.

Now, how much cooler is that?

The additional cash flow can be distributed directly to Jane, or her investors. Alternatively, it can be retained for improvements and renovations that can increase the value of the property, or be used as a down payment to purchase additional properties.

Is a Cost Segregation Right for Me?

Now before you start dreaming about that vacation to the Caribbean, you’re going to want to discuss with your tax professional if a cost segregation study is right for you.

There is a cost involved with having a study done, and the net benefit (or lack thereof) will depend largely on the property you own as well as other tax considerations.

Cost segregation has the potential to benefit any property. However, owners of larger multifamily or commercial properties will benefit the most from these studies and should definitely consider having a study done.

The Bottom Line

You don’t have to be part of the 1% to utilize cost segregation and significantly reduce your taxable income.

All it takes is a qualified tax professional that can help you decide if it’s the right fit for your rental property, and then walk you through the process.

If it is determined that a cost segregation study will benefit you, go ahead and book that Caribbean vacation courtesy of Uncle Sam!

P.S.

When you get back from your vacation, we’ll discuss how you can combine 1031 exchanges with cost segregation for maximum tax savings.

Topics: Tax Strategies

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