This federal tax planning tool helps investors boost their cash flows when purchasing, building, or renovating residential or commercial real estate.
Let’s dive into understanding cost segregation and how it can benefit you.
What is Cost Segregation?
Cost segregation is like a financial friend for real estate investors. At its heart, it’s a method that lets investors speed up the depreciation of their properties. Instead of deducting a bit of the property’s value each year, they can claim a larger amount early on. This translates to bigger tax deductions annually, saving a significant amount on taxes.
This strategy is perfect for those who’ve invested in various properties, from homes to retail spaces.
However, there’s an important detail: it only applies to investment properties, not the home you live in.
A cost segregation study must be completed to take advantage of the tax savings with cost segregation. This ensures that the deductions are accurate, optimizing the tax benefits.
Using cost segregation, real estate investors enhance their savings and free up funds for future investments or other requirements.
A Quick Refresher on Depreciation
Every tangible asset undergoes wear and tear over time. This reduction in value is accounted for as depreciation in the world of business finance.
The IRS usually says commercial buildings lose value over 39 years. However, with cost segregation, some parts of the property can lose value faster.
The How-To of Cost Segregation
Cost segregation might sound complex, but it’s quite straightforward when broken down.
The first step involves engaging a specialist, typically a CPA, with expertise in tax laws, construction methodology, and property valuation. This tax expert will look at the building plans, check the property, and assess everything from the wiring to the heating and cooling system.
Following their assessment, your tax expert determines which assets can be categorized into shorter recovery periods. Instead of waiting 39 years to depreciate a building fully, certain elements might be depreciated in 5, 7, or 15 years.
Cost Segregation in Action:
Meet John, a savvy business owner who bought a commercial building for $1 million. Usually, he’d get a monthly tax break for 39 years to account for his building getting older and wearing out. This is what we call “depreciation.”
Cost segregation could give John bigger tax breaks in the earlier years after his purchase. So, he hires experts to take a closer look at his building. The experts find:
- Parts of the building (like carpeting and fixtures) worth $200,000 could get him bigger tax breaks over five years.
- Outdoor improvements (like landscaping) worth $100,000 could give him tax breaks over 15 years.
- The rest of the building, worth $700,000, continues with the usual 39-year plan.
By using cost segregation:
- For the parts inside the building (the $200,000 part), John gets a tax break of $40,000 every year for five years.
- For the outdoor improvements (the $100,000 part), he gets a $6,667 tax break every year for 15 years.
- For the main building (the $700,000 part), he gets a $17,949 tax break every year for 39 years.
If John didn’t use cost segregation, he’d only get a tax break of $25,641 in the first year. However, with cost segregation, he gets a bigger tax break of $64,616 in the first year. So, John gets to keep more of his money in the early years!
The Rewards for Small Business Owners
There are tangible benefits to implementing cost segregation:
Enhanced Cash Flow: Speeding up depreciation means businesses can reduce their taxable income, especially in the initial years. This leads to more available cash, which can be reinvested into the business.
Transparent Profit Metrics: More accurate depreciation schedules offer business owners a clearer picture of their property’s profitability, which can be instrumental in decision-making.
Tax Management: The immediate benefits of cost segregation extend beyond mere savings. It gives business owners more control over their tax liabilities, ensuring they can efficiently manage their obligations.
Collaborate with Expert Tax Professionals
With its proven benefits and IRS acceptance, cost segregation presents a reliable and efficient way to optimize tax benefits. Collaborating with knowledgeable professionals can streamline the process and amplify its advantages.
Notion CFO and Advisors can help! Contact our expert tax advisors today if you are considering using cost segregation to reduce the taxes you pay each year on your investment properties.
