Own Real Estate? Cost Segregation for Tax Saving Acceleration: by Syed Nishat

Why cost segregation is important in Real Estate Investment: by Syed Nishat

Most successful self-employed business owners and physicians with their own practices own the real estate out of which their businesses operate. While owning the real estate attached to the business can be a savings in terms of rent and flexibility, it is also important to understand how a business real estate owner can save in taxes associated with the property. Having a strategy, like cost segregation, to minimize the effect of tax liability on real estate.

So, what is Cost Segregation?

Cost segregation is a tax planning tool that accelerates the rate of depreciation of components of property to thereby lower the amount of taxable income.

So what is depreciation in this context?

An asset’s value depreciates with time, due to usual usage and the effect that has on a property. Depreciation takes this loss of value due to wear and tear into consideration to lower the value of a property over time, which for residential property is 27.5 years while commercial property’s period is 39 years. Once the value of the property has gone down, the owner can write off more of it, which will lower the taxes owed.

While this depreciation for tax savings can only be applied to properties that are not the owner’s primary residence, such as a second house, retail space, or a commercial unit, there is no doubt that taking the depreciation value will help when looking at the value of something and the tax that will be levied against it. Most real estate tracks the value of the whole commercial property through the depreciation period, however, to maximize the benefit of depreciation, cost segregation can be key.

How does cost segregation work?

Rather than waiting out the full specified depreciation period, cost segregation allows for an acceleration of the depreciation rate of an asset. To do this, the owner of the property must have a cost segregation study or analysis completed for that property to initialize the process. This analysis will take into consideration certain elements of the property, which may include but not limited to :

• Carpeting
• The electrical system,
• Any specialized equipment in a kitchen
• Computer system
• Ventilation
• Flooring
• Piping
• Partitions
• Millwork, along with other aspects.

The included elements will vary based on the property type, and the recovery period, meaning the amount of time something can be depreciated, will be analyzed separately for these items. This process allows the property to be considered by those specific elements, rather than as a whole subject to the lengthier depreciation periods allotted to regular commercial properties, and those depreciated elements are technically reclassified as personal property. Because of this change in status, the depreciation period can be lowered to as little as five years.

For taxpayers who own real estate, this means writing off more due to the depreciated value, as established by the analysis, at a faster rate, maintaining more money for the business and its development. The optimization of cost segregation will increase cash flow, identify missed deductions, and reduce tax liability. But even these basic cost segregation advantages have been made more beneficial due to provisions in the Tax Cuts and Jobs Act of 2017.

Tax Cuts and Jobs Act (TCJA) reform and Bonus Depreciation:

To make cost segregation analyses more valuable, the tax reform made two changes, both of which affect bonus depreciation. Bonus depreciation allows businesses and individuals to deduct a certain percentage of the asset costs immediately, meaning the first year they are placed in service. Prior to the law changes, only new property could qualify, however now used property is eligible for this treatment. It also increased the bonus percentage to 100 percent through tax year 2022, rather than the expected 50 percent through 2019.

Let’s see how it works in practice:

So, what does this mean, in practice? Let’s look at an example. Consider a taxpayer in New York who purchases a building worth $15 million. Immediately after the purchase, they have a cost segregation analysis done on the property, and as a result 10 percent of the costs as personal property.  These assets that have been reclassified will now have a shorter depreciation schedule, and the taxpayer can also apply bonus depreciation in the first year. This means that they can write off $1.5 million of that $15 million purchase price. Taking this into consideration, a taxpayer with a 25 percent marginal tax rate would save $375, 000 in taxes that first year, or about 2.5 percent of the purchase price.

As there is some cost associated with a cost segregation study, it is a good idea for a taxpayer with commercial real estate interests, whether it’s property from which they operate their business or real estate from which they stand to gain rental income, to consult with experienced professionals, such as financial advisors and tax professionals, to see if they stand to gain from the analysis and the potential results of the study. If properties qualify for accelerated depreciation that will reduce tax liability in such a way that it benefits the taxpayer, this study is an invaluable tool to save in taxes and increase cash flow to continue to grow a business.

Cost segregation is one of the strategies physicians and self-employed real estate owners can use to increase cash flow and lower both their active and passive income. It is important to speak to experience fiduciary financial advisor who can look at your overall financial situation and advice based on your individual circumstances.