Cost Segregation Made Simple

Cost segregation is arguably the most powerful tax saving tool available to real estate investors. It allows you to accelerate the amount of depreciation you can claim on your taxes in the first few years you own the property. If you are looking for more deductions, look no further than cost seg. And here’s a simple explanation of how it works:

 

3 Depreciation Tax Strategies:

1. Standard (Straight Line) Depreciation

Standard or straight line depreciation is a yearly income tax deduction that permits you to recoup costs for wear and tear and deterioration of rental property while you own the property. The IRS allows you to depreciate your building, not the land and that depreciation is spread over twenty-seven and a half years.

Example of standard depreciation for a 10-unit, million-dollar commercial property: To calculate the value of the building we take off 20% of the value of the property for the land which means the building is worth $800,000. To calculate the depreciation, we take the value of the building, which is $800,000 and divide it by 27.5. From this we get a tax write-off or a depreciation of $29,090 per year for 27 and a half years. Regardless of they type of rental real estate you have; you should be taking advantage of this depreciation as a commercial real estate investor.

2. Accelerated Depreciation (Cost Segregation)

Cost Segregation is a tax strategy of accelerating your depreciation. Instead of depreciating it over twenty-seven and a half years, you can depreciate parts of a building over five years. This has a tremendous impact. One of the reasons why Donald Trump pays income taxes on his business dealings but not on his real estate is due to this tax strategy. He makes millions of dollars a year in cash flow but pays little income tax.

To implement this tax strategy, you need to hire a firm to do a cost segregation study of the building. In this study they will separate or segregate the property into four components:

• Land – 20% of total value
• Building – 50% of the value
• Land improvements – 10% of the value
• Personal property – 20% of total value

Land improvements include things like walkways, the parking lot, and fences. Personal property includes items like appliances. For example, I had a 44-unit property, and the cost segregation study included the 44 washing dryers, 44 stoves, and 44 refrigerators. All those appliances added up to hundreds of thousands of dollars that I can write-off over five years. I didn’t purchase all those appliances, but that’s the beauty of cost segregation.

Example of cost segregation or accelerated depreciation for a 10-unit, million-dollar commercial property: Between the land improvements and personal property, you can write-off 30% of a million dollars over five years. To determine the accelerated depreciation, first we calculate 30% of a million dollars, which is $300,000. Divide that by 5 years and you receive $60,000/year.

By using the cost segregation tax strategy, you just doubled your depreciation and that doesn’t even include the building! This is such an effective strategy right now because with our rapid inflation, the longer you leave your money in the property, the less it’s worth. And if you have the skillset of taking this money and multiplying it with commercial real estate, why wouldn’t you put that money to work?

3. Bonus Depreciation

When Trump signed the Tax Cuts and Jobs Act, he added something called bonus depreciation. This is a very powerful tool for commercial investors. In the above example, it allows you to take the entire $300,000 of cost segregation depreciation in year one. That’s right. In the first year that you own the property you can write-off 100% of the depreciation. It goes immediately against your adjusted gross income. Let’s say you make $200,000 a year and you take the entire $300,000. That means you get a tax refund check of $100,000.  You can then take that cash and purchase another commercial property.

DISCLAIMER: 100% bonus depreciation will start to fizzle out at the end of 2022. In 2023 it will begin dropping by 20% each year until it is phased out in 2027. That means you need to have a sense of urgency to buy your commercial property, cash flow it, and do a cost segregation NOW. Get that tax refund and buy another property now because the bonus depreciation is a temporary measure.

 

Cost Segregation: A Powerful Tool for Commercial Real Estate Investors

Accelerated depreciation or cost segregation is particularly powerful if you have investors or if you have a large property. To illustrate the impact cost segregation can have on commercial investing, let’s use the example of a 100-unit property that was purchased for $7 million.

Scenario 1: Cost Segregation for Large Apartment Complex

Again, we segregate the property into four components:

• Land – 20% of total value
• Building – 50% of the value
• Land improvements – 10% of the value
• Personal property – 20% of total value

The land improvements and personal property amount to 30% of $7 million, which is $2.1 million. So, we can accelerate the depreciation and write-off $2.1 million over the next 5 years, which equals roughly $420,000/year. This $420,000 goes directly against adjusted gross income. In theory, for the next five years you won’t have to pay income tax.

Scenario 2: Bonus Depreciation for Syndicated Property

How would this calculate if you purchased this same property with ten investors? In this scenario, we will take advantage of the bonus depreciation and take the entire $2.1 million in year one. When divided between the ten investors, each investor will receive $210,000 depreciation in year one. All ten investors can use this against their adjusted gross income, pay no taxes and carry what is left over to the next year and subsequent years until it is used up. Imagine at the end of the year telling your investors they don’t have to pay income tax on the cash flow from their investment property, AND they can use the extra depreciation to wipe out their personal income as well! This is why cost segregation is such a powerful tool for the real estate investor.

 

Pros and Cons of Cost Segregation

Now with every plus there is a minus, and this principle applies to cost segregation as well. These factors are often ignored when considering cost segregation, but they are important and need to be addressed.

Con #1: A Cost Segregation Study Costs Money

In the first example of a 10-unit, million-dollar property, a cost segregation study will cost between $4,000 and $5,000. However, it’s worth it to save $300,000. For the 100-unit property, you can expect to pay $20,000 for a cost segregation study, but again, it’s worth the initial costs.

Con #2: Depreciation Recapture

When you do a cost segregation or when you depreciate anything in real estate, there’s always a recapture component when you sell the property. When you write the depreciation off over five years, you get significant write offs, but if you sell the property, you will have to recapture that at about a 25% tax rate.

Some investors argue that you shouldn’t do a cost segregation because at the end you are required to pay it back. I have two thoughts on that. Number one, I look at cost segregation as a zero-interest loan from the government. Secondly, with the cash that I get from accelerated depreciation I’m immediately investing in another property or increasing my return in the property to make it cash flow more which in turn pay for the recapture expense. It all depends on how you think about it.

Con #3: If Too Aggressive, IRS Will Penalize

If you write off too much, the IRS may penalize you. Therefore, I recommend you not have your accountant do your cost segregation. You should have your accountant refer you to a company that specializes in cost segregation studies.

Con #4: There are Limits to Write Offs

If you are not a real estate professional, then you are limited on what you can write-off on your rentals. There are also limits depending on how much money you make. If you make a certain amount of money every year, you aren’t entitled to any write-offs. So long as you’re under that threshold, you can take advantage of accelerated depreciation.

Con #5: Bonus Depreciation Will Phase Out

Starting at the end of 2022 bonus depreciation will begin to be phased out, reducing by 20% each year until it is eliminated. So, there is a sense of urgency for you to take advantage of this bonus depreciation now. Buy your property, cash flow it, do a cost segregation study, get your tax refund, your tax savings and use that money to buy another property ASAP this year.

Pro #1: Wealth Building Strategy

I see cost segregation as a wealth building strategy, not tax avoidance. You really can’t avoid the tax because you must recapture when you sell the property.

Pro #2: You Get Your Money Now

Rather than waiting over the next twenty-seven and a half years, you get your money now. Since inflation is pushing costs up and the value of the dollar is going down, the sooner you get your cash out to buy your property, the more money you make.

Pro #3: Cost Segregation Study May Reduce Insurance Premiums

This year insurance has skyrocketed on our commercial properties, sometimes double. Cost Segregation may help you get those premiums pushed back down.

Pro #4: Real Estate Professionals Have Unlimited Write-Offs

If you are a real estate professional as deemed by the IRS, you have unlimited tax write-offs. That means you can cost segregate every property and get all the write-offs. Again, remember cost segregation produces paper losses. So, you may have made $200,000 in cash flow, but it will look like you’re losing money cashing out your pocketing money. Then that negative balance can carry over year by year until it’s used up. Every year you make money, you can use that money to mitigate any tax you have to pay on dollars you made. Those are the incredible benefits of being real estate professional.

I have an informative video called Tax Benefits of Commercial Real Estate. Check it out to learn more about the tax advantages you have as a commercial real estate investor.

Pro #5: Boost Your Cash Flow

As a syndicator or if you have partnerships, cost segregation can immensely boost your cash flow. As I explained above in the syndication example, all these tax write-offs from a cost segregation flow down to each investor individually. So, your investors, not only will they not pay income tax on the profits from the property, but that tax rate will also flow down into their adjusted gross income from their W-2 job and potentially wipe that off too. They’ll have all their job income and real estate income and pay zero tax.