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Where Does Cost Segregation Fit Into My Real Estate Investment Strategy?

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Cost segregation

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    A cost segregation study is one of the most powerful tools in a real estate investor’s arsenal. These studies provide a mechanism that investors can use to accelerate depreciation schedules and minimize taxable income on properties including commercial and residential real estate. 

    Recent years have seen cost segregation studies become increasingly attractive due to bonus depreciation rules in the 2017 Tax Cuts & Jobs Act. These rules allow 100% of bonus depreciation expenses to be written off the same year the expenses were incurred. 

    However, these bonus depreciation rules are scheduled to be phased out from 2023 onwards. Bonus depreciation will reduce to 80% in 2023, with subsequent 20% annual reductions before being eliminated in 2027. That means time is running out for investors looking to maximize tax savings. 

    While cost segregation studies represent a great strategy for many real estate investors, they’re not always the best approach. These studies are expensive and you’ll want to be sure you can realize significant tax benefits before committing to a study. 

    What is Cost Segregation?

    When an investor purchases a property, the property is depreciated over a number of years. For residential properties, depreciation occurs over 27 and a half years while for non-residential properties, it’s 39 years. Cost segregation allows investors to pull forward some portion of this depreciation, unlocking immediate tax savings. 

    When a property is acquired, you aren’t just buying the building itself, you’re also buying everything inside the building. That includes components like appliances, carpets, and windows. These components, depending on how they’re classified, are eligible to be depreciated over faster timelines: 5, 7, or 15 years.

    A cost segregation study identifies these components and assigns them a value. On average, between 20% to 30% of a property’s value is eligible to be depreciated over 5, 7, or 15 years. This offers significant tax benefits for investors. 

    When Does It Make Sense to Do a Cost Segregation Study?

    There are several scenarios where it makes financial sense to conduct a cost segregation study. Let’s take a look at the most common:

    After Acquiring a New Property

    Purchasing a new property is the most common motivation for undertaking a cost segregation study. That’s true both for real estate professionals as well as investors who qualify through the short-term rental property loophole.

    Conducting a cost segregation study creates a non-passive loss that you can use to offset active income. If the loss is large enough, it can be carried over into future years. That means even if you reduce your taxable income to zero or hit excess business loss limits, you can still recognize losses in future years.

    It often makes sense to do a cost segregation study even if you’re not a real estate professional or don’t qualify for the short-term rental loophole. However, losses will be treated as passive and can only be deducted from passive income. That includes income from rental properties or gains on the sale of a property. These losses can also be carried over into future years.

    As an Alternative to a 1031 Exchange

    If you sell a property and acquire another property later in the same calendar year, you can use a cost segregation study as an alternative to a 1031 exchange. Completing a cost segregation study on your new property can show significant losses. You can use these to offset the gains made on the sale of the other property. 

    You can also do this by investing in a real estate syndicate. Provided the syndicate plans to complete a cost segregation study, you can use the syndicate’s losses to offset your gains. This applies whether you sold a property or received a gain from another syndicate. 

    Partial Asset Dispositions 

    When you acquire a property and place it in service, you may start doing major capital improvements that remove part of the property. Partial asset dispositions allow you to deduct the value of the components that were removed. 

    Here’s an example: you replace an existing roof with a new roof. Both the old and the new roof can be depreciated on a standard 27.5-year depreciation schedule. A partial asset disposition allows you to deduct the full value of the old roof the year you replace it. 

    In this scenario, a cost segregation study is completed in two phases: when you first purchase the property and after renovations are complete. The study will assign a value to the old roof which you can then deduct in full that tax year. 

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    When Does it Not Make Sense to do a Cost Segregation Study?

    While there are many scenarios where a cost segregation study does make sense for investors, there are also instances where it’s not the best option. Let’s explore these scenarios:

    If You Plan to Become a Real Estate Professional in Subsequent Years

    If you don’t yet have real estate professional status, but plan to secure that status in the next two or three years, consider waiting to undertake a cost segregation study. Cost segregation studies can be done retroactively, and you’ll be able to retroactively claim the depreciation expense that you would’ve taken in the first year of ownership.  

    Waiting until you have real estate professional status ensures losses are treated as non-passive. If you pursue a cost segregation study before securing this status, your losses are locked in as passive and can only be deducted from passive income. This cannot be changed in later years. 

    Properties That Have Been Owned for Several Years

    It’s certainly possible to perform a cost segregation study retroactively, but if you’ve owned a property for several years it’s unlikely a cost segregation study is worth the investment. 

    In the time you’ve owned the property, you’ve been taking depreciation on a standard schedule. This limits the tax savings you could realize with a cost segregation study. Amending your tax returns to claim depreciation expenses retroactively is complex, and you may incur additional CPA fees. Both these factors mean that the longer you’ve owned a property, the less feasible a cost segregation study is.

    Properties Worth Less Than $500,000

    If your property is worth under $500,000, it’s often not worth it to complete a typical cost segregation study. These studies involve specialized engineers and accountants, and typically cost thousands of dollars. Often, the tax savings don’t justify the expense. 

    However, you can perform a desktop cost segregation study using online software. This approach is cost-effective for properties with lower acquisition values. 

    Want to Learn More About Real Estate Investment Tax Strategy?

    Cost segregation studies represent an incredibly effective tax strategy for many real estate investors, but they’re not always the perfect solution. In fact, they’re just one of many tools that tax professionals have at their disposal to create effective tax strategies for real estate investors. 

    Interested in learning more about real estate tax strategies? Join the Tax Smart InvestorsTM group to meet like-minded investors and get affordable real estate advice.

    Want to speak to a real estate tax professional to determine whether a cost segregation study makes sense for you? Schedule an initial consultation today!

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    ★★★★★

    Hall CPA PLLC, real estate CPAs and advisors, helped me save $37,818 on taxes by recommending and assisting with a cost segregation study. With strategic multifamily rehab and the $2,500 de minimus safe harbor plus cost segregation, taxes on my real estate have been non-existent for a few years (and that includes offsetting large capital gains from the sale of property).

    Mike Dymski - Business Owner