Does real estate really have all the tax breaks that people talk about? Real estate has always been a very important investment for many people. Business owners and real estate investors alike have benefited from many of the IRS rules surrounding their properties. As many of the top real estate investors may know, utilizing the cost segregation strategy could mean a difference in hundreds of thousands in your taxes.
What Cost Segregation Is and How It Works
Cost segregation is an extremely valuable tax planning tool for business owners and investors with real estate properties. When used correctly in the right situation, it could mean the difference in $100,000+ in tax deductions in a given year.
Cost segregation is simply about restructuring the depreciation schedule of a property. Most investors will buy an investment property, and their CPA would likely automatically file their taxes with what is called “straight-line depreciation”. This means over the life of the property, each year you can deduct a portion of the house from your taxable income.
The IRS has pre-determined rules for depreciating properties over time. Residential real estate can be deducted over 27.5 years and commercial real estate over 39 years. So, for example, if you buy a $500,000 residential rental property, you would likely deduct $18,182 each year on your taxes ($500k / 27.5).
The cost segregation strategy allows you to break up the straight-line depreciation schedule and move deductions from the later years toward the front. Instead of waiting each year to deduct 1/27.5th of the property, you can bunch deductions in the first few years and claim significant tax deductions against your income. This is also known as accelerating depreciation.
Benefits
This has created an incentive for real estate investors to purchase even more qualified property. When you hear everyone say how real estate investing is great for taxes, this is one situation where they are right. Having rental income is not for everyone, and often getting into residential or commercial rentals is not appropriate, but for those who already own properties, this tool could be an excellent addition to your financial plan.
One of the primary benefits is the increased cash flow. The more you deduct today (or in the first few years), the more cash you have to invest. But importantly you are forgoing more of the deduction in later years. However, if you ask most business owners, I’d guess they would rather have a dollar today than wait and receive it 20 years from now.
More cash or capital generally leads to more investments, which hopefully increases the probability of a healthy return on the real estate enterprise. If an investor thinks they can generate a return today that would offset the “lost deduction” later on, then cost segregation may be worth considering.
Cost segregation may complement other tax strategies as well, such as bonus depreciation, to maximize benefits. Since the creation of the Tax Cuts and Jobs Act (TCJA), many owners who have used the cost segregation strategy were able to accelerate the deductions not just earlier, but entirely in the same year as the property was purchased.
Until the last few years, business owners could deduct 100% of the value of property that had a “life” of less than 20 years. With the near expiration of part of TCJA, that has now dropped down to 60% for 2024 and will drop by 20% each year until it expires. Check out my article on the TCJA expirations to learn more.
Drawbacks
As with any strategy, by focusing on one area you are naturally giving up another. That is the entire point. The cost segregation strategy does accelerate deductions, but that means you are losing the deduction in future years. Therefore, without considering anything else there are technically no tax savings (assuming a constant tax rate), you are just shuffling around the deductions you would already get in the future.
This also could be problematic when you go to sell the property. The IRS has instituted “depreciation recapture” on properties sold for a gain. The rules here can get very complicated, so it is important to work with a knowledgeable tax professional to do it correctly. In some cases, the IRS requires the amount that was previously deducted to be recaptured as part of the profits on the sale. So, this recapture should be included in the initial analysis of the cost segregation.
The all-in expense to complete the cost segregation is not necessarily cheap either. Between professional fees and the cost of the cost segregation study itself, expenses could generally be anywhere from $5,000 to $20,000 in fees to execute. This is why it is important to run the numbers and verify the trade-offs. Paying a few thousand to get back a few hundred thousand could be a good deal.
How It Works
Obviously, the first step towards benefiting from the cost segregation strategy is to own residential or commercial rental property. Since the strategy involves depreciation over the life of the property, considering a cost segregation study as close to the year of purchase would produce better results. As we have seen with the bonus depreciation, owners in previous years have benefited the most by deducting the entire value in the same year as the rental was purchased.
Next is to conduct the cost segregation study. There are tax professionals and cost segregation specialists who can access the property for you and help you maximize the deductions possible. It is technically possible to do it yourself or have your current CPA do it. But as with any specialization, those who do nothing else but cost segregation studies could provide more than enough value to justify a higher fee.
Lastly, work with your advisor and tax preparer to create a long-term game plan. Reducing taxes is one part of a larger personal finance ecosystem for business owners, and taking advantage of lower taxes can be beneficial for other financial areas. Roth conversions, new investment properties, paying off debts, hiring new employees, building cash reserves, and many other strategies could help make a cost segregation that much more useful.
Cost Segregation
When it comes to tax planning and real estate investments, the cost segregation strategy can be a significant change to your taxes. When done correctly, business owners with larger real estate properties can make 6-figure changes to their tax situation in a given year. The flexibility of altering taxes can create many other planning opportunities to help you create a solid overall financial plan. Take the time to do your homework, and work with professionals to help you determine if the cost segregation strategy is right for you.
TC Falkner 