Cost Segregation Study – How To Seriously Lower Your Taxes
Cost Segregation Study
One of the biggest expenses doctors and other high-income earners face are taxes. In the past, I’ve shared tax strategies that can help us save thousands or more per year.
Now, I want to make it clear that I’m a periodontist and NOT a CPA. If you have tax questions, especially when it involves real estate, I encourage you to speak with your accountant or one that specializes in real estate such as Keith over at The Wealthy Accountant or The Real Estate CPA.
I started investing passively in real estate, particularly in syndications, about three years ago due to several reasons:
- Capital Preservation
- Cash Flow
- Tax Benefits
- Passive Income Stream
Honestly, what really motivated me was that I got tired of always hearing about how the wealthy were paying little to no taxes. I wanted a piece of that too!
When I looked into it why that was the case, I noticed a common denominator: Real Estate
Little did I know that virtually anyone can benefit from the tax system as long as they know how to play the game. There’s tons of information online, in books, and on podcasts that is available to anybody that really wants to learn how to invest in real estate which will free themselves from having to trade their time for money.
One of the “secrets” that real estate investors use to pay little or no taxes on the income from their rental real estate is with cost segregation.
Let’s uncover exactly what this secret is all about…
What’s A Cost Segregation?
My good friend Joe Fairless defines a cost segregation as a strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes.
Cost segregation study
A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations.
A cost segregation study is typically performed by qualified engineers and/or CPAs.
The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for non-residential real property).
- 5-year tax-life components: tangible, personal property assets (carpeting, secondary lighting, process related systems, cabinetry, ceiling fans, etc.)
- 7-year tax-life components: all telecommunication related systems (cabling, telephone, etc.)
- 15-year tax-life components: land improvements (parking lots, driveways, sidewalk, curbs, landscaping, site features like a flag pole or a pond, etc.)
Personal property assets found in a cost segregation study generally include items that are affixed to the building but do not relate to the overall operation and maintenance of the building.
Land Improvements generally include items located outside a building that are affixed to the land and do not relate to the overall operation and maintenance of a building.
Reducing tax lives results in:
- accelerated depreciation deductions
- a reduced tax liability
- increased cash flow
Recent tax law changes under the Tax Cuts and Jobs Act of 2017 have given a boost to cost segregation.
Bonus depreciation was increased from 50% to 100% on certain qualifying assets.
Real estate investors will receive immediate expensing of certain 5, 7 and 15 year property. The Act also allows used property that was acquired after Sept. 27, 2017 to qualify for this special depreciation treatment.
That means real estate investors can deduct 100% of 5, 7, and 15 year property all in the first year.
As you can see, this is what makes cost segregation so powerful and can lead to significant tax savings.
A quality cost segregation study will separate any costs that qualify under the new bonus depreciation rules.
Is There A Minimum Purchase Price?
Something else you should know is that cost segregation only works on buildings (residential income property, commercial property, additions and build-outs) with an original cost basis (purchase price, plus additions) of $250,000 or more.
Remember, this does not include the value of the land.
For instance, if you purchase a property for $650,000, the land value usually comes in around 20% of the purchase price.
In this example, $470,000 is for the building and cost segregation works on the building portion of a property only.
Benefits Of Cost Segregation
As previously mentioned, cost segregation can:
- reduce taxes
- greatly increase the cash flow of a property
For example a typical $1 million asset is going to provide the owner between $50,000 and $150,000 in federal income tax savings.
If the cost segregation study resulted in $90,000 in tax savings and the investor owed the IRS $90,000 in federal income tax, then that just paid 100% of the tax debt. Not too shabby.
A Powerful Example
Here’s the power of just what a cost segregation study can do to lower taxes for real estate investors via The Real Estate CPA:
Jane Doe, who is in the 24% tax bracket, buys a 24 unit apartment building for $1,000,000, places it into service in 2018, and does not utilize a cost segregation study.
Her CPA determines the following:
The building is then depreciated over 27.5 years, allowing her to take $29,090.91 as an annual depreciation expense.
Her income and expenses were as follows:
Jane will have to pay taxes on the $90,909.09 received from the property. However, the depreciation expense reduced her tax liability by $6,981.82, and since depreciation is a noncash expense, Jane will still have the $29,090.91 in cash.
But wait, it gets better.
Now, let’s say Jane decided to have a cost segregation study performed on her property.
The study finds that the value of the property is broken down as follows:
Thanks to the Tax Cuts and Jobs Act, Jane can take 100% bonus depreciation on the 5-year property, and land improvements in the first year.
The building is still depreciated over 27.5 years, allowing for an annual depreciation deduction of $13,090.
This gives her a total depreciation deduction in year one of $453,090.
Let’s take a look at how this affects her income this time around:
As you can see, Jane will show a net loss of $333,090 in year one. That means she will not have to pay any federal or state taxes on the $120,000 of net income. That’s $28,800 ($120,000 x 24%) in tax savings!
Plus, the remaining $333,090 loss will be carried forward and offset income in future years.
Do I have your attention now?
The additional cash flow can be distributed directly to Jane, or her investors. Alternatively, it can be retained for improvements and renovations that can increase the value of the property, or be used as a down payment to purchase additional properties.
If you’re like me, busy and don’t have time to be a landlord, being an active real estate investor is not too appealing.
That’s why I started investing passively in syndications. I love the fact that my portfolio is diversified between the stock market and real estate.
Creating extra income streams + receiving tax benefits via these types of investments will help you reach financial independence much faster than you thought you could.
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