Real estate depreciation has some big tax advantages for property owners. Utilizing the proper depreciation rules on real estate assets allows you to deduct substantial amounts of the purchase price and/or improvement costs of a property, in turn dramatically reducing your taxable income.
But it gets better. The process of cost segregation uses accelerated depreciation which results in even greater tax savings and cash flow opportunities. In this guide, we cover the following topics:
- What is Cost Segregation?
- New Tax Law Changes Making Cost Segregation More Valuable
- What is a Cost Segregation Study and How Does it Work?
- 5 Benefits of a Cost Segregation Study
- Cost Segregation in Action – Two Examples
What is Cost Segregation?
Reclassifying Assets to Accelerate Depreciation
Cost Segregation is a powerful tax planning strategy that allows real estate owners (who have purchased, built, expanded or remodeled any kind of real estate) to take advantage of accelerated depreciation deductions in order to increase cash flow and reduce taxes.
At its core, cost segregation is the process of breaking down the various interior and exterior components of a property and reclassifying them into four main categories:
- Personal property (such as flooring, cabinets, moldings, carpet and specialty lighting)
- Land improvements (such as landscaping, parking lots, retaining, etc.)
- Real property (basic building components)
Assets that fall into the personal property or land improvements categories qualify for shorter useful lives under accelerated methods of depreciation. This means you can shorten the depreciation time from the standard 27.5 or 39-year straight-line depreciation schedule to 5 or 7 years (for personal property) or 15 years (for land improvements).
The result is substantial cash flow benefits and tax savings.
NEW Tax Law Changes Make Cost Segregation Even More Valuable
While there is a general awareness of cost segregation and its benefits within the real estate community, many property owners are unfamiliar with recent tax code changes that make it even more valuable than before.
The Tax Cuts and Jobs Act (TCJA) now allows 100% bonus depreciation for all the personal property and land improvement property constructed or acquired after 9/27/17. This is equivalent to expensing these items. Prior to that, bonus depreciation was only 50% and only valid for new construction.
With bonus depreciation now at 100%, for every $1M in building costs, the average building owner can receive cash flow increases of $90K to $220K in the first year of ownership, compared to roughly $15K under the former rules.
In March 2020, the CARES Act made cost segregation even more advantageous. Prior to the CARES Act, interior improvements on a nonresidential building (known as qualified improvement property or QIP) were required to be depreciated over a 39-year schedule.
The CARES Act retroactively corrects the depreciable life of QIP from 39 years to 15 years, delivering a much shorter depreciation period and making it eligible for 100% bonus depreciation.
Expanded carry backs of losses are another benefit associated with the CARES Act. Losses can now be carried back as much as five years allowing the investor to obtain refunds on taxes as far back as 2015.
What is a Cost Segregation Study and How Does it Work?
A cost segregation study is one of the most powerful tax strategies available to commercial property owners and real estate investors. If you own a property, your assets may include not just a building and land, but also all of the building’s interior and exterior components. As described above, a significant portion of those assets fall into tax categories that can be depreciated much faster than the building itself.
A cost segregation study aims to identify all components and costs related to a real estate asset (including both constructed and acquired properties) and reclassify them in order to take advantage of accelerated depreciation methods. Ultimately, the study aims to isolate all personal property and land improvement costs that can be depreciated over 5, 7 and 15 years, instead of the standard 27.5 or 39-year schedule of depreciation. The study will also take into account recent tax law changes in the TCJA and the CARES Act, among others, that provide new opportunities for even more cash flow.
An engineering-based cost segregation study assesses all information on a property such as real estate records, receipts, architectural and engineering drawings and cost data. It will also involve a physical inspection of the property.
Then, the findings are described in a comprehensive report. The report typically includes a property description, an engineering-based cost accounting of the components that fall into the four categories described above, methodology for any assumptions made and references to relevant tax law.
Another valuable aspect of a cost segregation study is that it can be performed on a building placed in service in the past using a look-back study. If a proper cost segregation study has not be performed, property owners can “catch-up” the additional depreciation in order to obtain more cash flow.
Because you’ll want to avoid being challenged under audit by the IRS, it is important that cost segregation studies be prepared only by a team of experienced professionals, generally qualified engineers and/or tax professionals, who have a thorough understanding of IRS standards, tax laws, accounting, engineering, construction methods, building materials and construction costs. The IRS requires all cost segregation studies be “engineering based,” which demands that a range of building components be analyzed, such as plumbing, electrical and mechanical systems.
A cost segregation study can be prepared at any time for significant tax savings. However, the ideal time for property owners is upon completion of construction or remodeling, or during the first year a building is purchased.
Benefits of a Cost Segregation Study
As we’ve discussed, a cost segregation study can considerably reduce your tax burden and increase the cash flow of a property, especially in its initial years of operation. Let’s take a quick look at 5 major cost segregation benefits.
- Significantly Increase Cash Flow. A cost segregation study can generate a rapid cash flow through accelerated depreciation deductions resulting in reduced tax liability. With bonus depreciation at 100%, for every $1M in building costs, the average building owner can receive cash flow increases of $90K-$220K in the first year.
- The results of the study can be carried back by 5 years or carried forward almost indefinitely . Any losses resulting from the study will be able to be used up by either carrying the losses back and getting a refund from past tax years or, if you choose, to carry any unused portion of the losses forward up to 20 years.
- Opportunity to Correct and Reclaim Past Depreciation Deductions. A cost segregation study enables property owners to correct misclassified components and catch-up the additional depreciation.
- A Detailed Cost Breakdown. Having a cost segregation study performed gives property owners an itemized list of all the components that comprise their building. This allows owners with justifiable numbers to use for write-off during any future renovations.
- Return on Investment. The latest tax code changes have increased ROI’s for cost segregation studies significantly. It is common to see them greater than 50 to 1 compared to a level of 20 to 1 prior to recent changes. Returns can be even higher – we have several recent studies with ROI’s of greater than 200 to 1.
Cost Segregation in Action – Two Examples
Example 1 – A Lookback Study
An effective way to demonstrate the value of cost segregation is to compare a property with and without the study. In this scenario, an investor builds an apartment complex for $20.4 million in 2018. Typically, this cost would be depreciated over the standard 27.5-year straight-line schedule. In this case, the investor’s accountant was able to take advantage of some accelerated property ($3.5 million) based off of the contractor’s pay application. After 2 years, the investor’s accumulated depreciation amount added up to $4.8 million.
Consider the same property using cost segregation. In 2020, this investor opted to have a cost segregation study performed on his apartment complex. They found a current accelerated depreciation of $5.9 million after the study and an increase of $1.1 million in depreciation for the year 2020. Using a combined Federal and State income tax bracket of 40%, the property owner’s increased cash flow will be over $400,000 in 2021.
The cost segregation study allowed this investor to take advantage of more accelerated depreciation deductions in order to boost cash flow in the short term. He understands that the upfront cash flow is worth more than it would be 20 years from now.
Example 2 – A New Construction Study
In this scenario, a new office building is constructed in 2020 and for a total project cost of $42 million. The real estate owners decided to have a cost segregation study performed upon completion of construction. The study identified nearly $8 million in accelerated depreciation deductions, which amounted to a first year tax savings of $3.1 million. The ROI on the study was 347 to 1.
This example illustrates how valuable a cost segregation study can be for new construction projects. When performed upon completion of the project, the study can generate considerable tax savings.
Overall, cost segregation can be an extremely valuable strategy for property owners and real estate investors. For more information on how a cost segregation study can help your business now more than ever, contact The Concord Group.
Our free cost segregation assessment provides a realistic estimate of the tax savings you may be eligible for. Our experienced team has a thorough understanding of construction methods, materials, and costs, which can mean the difference between getting some of the benefits versus all of the benefits.