Cost Segregation Explained and Why it Could Be Part of an Effective Tax Strategy
Real estate investment is attractive for many reasons. It offers the potential for regular cash flow. It often outperforms other investment vehicles. And it helps your money keep pace with inflation in a way that’s difficult to replicate.
There are tax benefits to real estate investing as well — if you know how to identify and take advantage of effective tax-saving strategies.
A cost segregation study or analysis is one of the most effective approaches to realizing tax savings related to a real estate investment.
What is Cost Segregation?
Depreciation is a common tax dedication that allows filers to recoup the initial cost of property over the period of time that the property is in use. Simply put, cost segregation allows owners of real estate to accelerate the depreciation schedule for certain components of the property. Cost segregation can be used on both residential and commercial properties to help reduce taxable income.
Depreciation schedules are set at 27-and-a-half years for residential properties and 39 years for commercial properties. But think of all the components inside a property that might need to be replaced over shorter periods of time — things like fixtures, windows, appliances, etc. Cost segregation allows you to depreciate those components over 5-, 7- or 15-year windows.
In effect, when you use cost segregation, you’re pulling forward depreciation’s tax benefits for some portion (typically around 25%) of your property so that you can enjoy those savings immediately. For example, pulling forward depreciation using cost segregation can help offset rental income and reduce your overall tax obligation.
But, to use cost segregation as a tax-savings strategy, you’ll need to hire a specialist to conduct a cost segregation study or analysis, which can cost thousands of dollars. Given the expense of a cost segregation study, it’s not always the right choice.
COST SEGREGATION STUDY - EXAMPLE
When Should You Have a Cost Segregation Study Done?
Let’s start with the reasons why you should conduct a cost segregation study. Here’s a look at three compelling reasons to move forward with one:
You’ve just bought a new property. The further you get down a traditional depreciation schedule, the lesser the benefit of a cost segregation study. But, conversely, the ideal time for a study is when you’ve just purchased a new property. Use a cost segregation study to offset income with a non-passive loss. You can carry over your non-passive losses to future years. There’s one caveat, though: Only real estate professionals can create a non-passive loss through a cost segregation study to offset active income. If you’re not a real estate professional, losses identified through a cost segregation study will be treated as passive and can only offset passive income.
You want to use a partial asset disposition. Partial asset disposition is used when there’s a major capital improvement. For example, imagine your property requires new flooring, a new HVAC unit or a resurfaced parking lot. Partial asset disposition lets you deduct the full value of the old flooring, HVAC unit or parking lot in the same year that it was replaced. Cost segregation studies are conducted in two parts in this scenario, an initial study before capital improvement and a subsequent study afterward.
You need an alternative to a 1031 Exchange. If you sell a property and buy another in the same year, you can use a 1031 Exchange to defer any tax liability in that year. A cost segregation study can be used as an alternative, though. Use cost segregation studies to show losses on your new property so that you can offset any gains realized via the sale of your previous property.
Here are three reasons why you should wait on or skip the cost segregation analysis:
You’ve owned the property for a while. As mentioned above, cost segregation studies can be expensive. If you’ve owned your property for more than just a few years, it’s unlikely that the study will deliver the tax benefits you’re looking for.
Your property is lower in value. As a general rule, the higher in value a property, the greater the tax benefits. The lower the value of a property, the lower the tax benefits. If you have a property that’s worth a few hundred thousand dollars (compared to a few million or more), the tax benefits may not be worth the investment in a study.
You’re planning to become a real estate professional. If you conduct a cost segregation study before you become a real estate professional, your losses are passive and can only offset passive income. So, if you’re planning to become a real estate professional, wait to conduct a study so that you can claim non-passive losses that can offset active income.
Now is the Best Time for a Study
There’s no rush to have a cost segregation study conducted in some regards. For example, you can conduct one in 2023 leading up to the tax filing deadline for 2022. You don’t have to conduct a study in 2022 to claim depreciation-related deductions for 2022.
But, in other regards, now is the best time to conduct your study. Thanks to the 2017 Tax Cuts & Jobs Act, 100% of bonus depreciation expenses can be written off in 2022. This benefit is phased out over time, with only 80% of bonus depreciation being deductible in 2023, and then 20% annual reductions until the benefit is fully phased out in 2027.
Learn More About Real Estate Investing
Do you want to learn more about real estate investing? At Madison Investing, we’ve created a free course that walks you through how to set goals and then pair those goals with effective investment strategies. Called “Blueprint,” this course is a natural first step to educating yourself on strategic real estate investing — and to determine how you can get started.