Through cost segregation, you may be able to save thousands of dollars on your annual tax bill. If you have recently purchased a real estate property, this investing tip will allow you to separate different aspects of your investment. Recently, we conducted an interview with one of our clients who saved $28,500 on his taxes by using a cost segregation strategy.
How Cost Segregation Works
Slocomb paid $28,500 less to the Internal Revenue Service (IRS) in 2019 because of a property he invested in. He achieved these impressive savings from a technique known as cost segregation. When you buy a property, you purchase the building and the land it is on. In reality, you are also buying all of the assets associated with the property as well. You only pay one lump sum before you are given the property.
If our client had just bought the property and did not do cost segregation, he would normally depreciate the cost of his property over the following 27.5 years. Cost segregation changes this equation. With cost segregation studies, you can accelerate your property’s depreciation and get a shorter recovery period.
For real estate investing, you can use this strategy after you buy, build or acquire a property. It can be used with a 1250 property or a residential property. While a residential property normally gets a strain-line depreciation over 27.5 years, a 1250 property has a straight-line depreciation that lasts for 39 years.
With cost segregation, you can depreciate interior and exterior parts of your property over 5, 7 or 15 years. This allows you to lower your tax bill in the short run by depreciating the property earlier than normal. Because of this, you can boost your profitability and tax flow from passive investing.
A cost segregation study is typically done by someone who has experience in construction, engineering tax accounting or architecture. The professional will look at some of the following components of your property.
- Phone systems.
- Electrical equipment.
- Wall coverings.
- Kitchen equipment.
- Process piping.
- Storage tanks.
- Concrete slab floors.
- Specialty plumbing.
- Light fixtures.
- Mill work.
- Ventilation systems.
- Computer systems.
During the next step in the cost segregation process, the professional will separate out each item from the study. They will then determine how long each asset can be depreciated. Because the project type and the kind of property you have will determine which assets are qualified assets, it is important to hire an expert to conduct this study. With the help of an expert, you can make sure your tax savings are calculated correctly.
An Example of Cost Segregation
Whether you are interested in active investing or passive investing, cost segregation is a useful tool you can use to reduce your tax bill in the short run. Slocomb had more than 20 units, which means his property easily had 40 appliances. After considering his purchasing price, we broke down the cost of the appliances, cabinets, counters, blinds and other items.
Once we broke the property down into a list of its components, we could look at the depreciation terms for each specific item. The lifespan of each item is important because short lifespans let us do bonus appreciation. We can also access faster depreciation schedules when we depreciate items individually instead of depreciating the entire property at once.
As a real estate professional, Slocomb was able to use all of our results to reduce his taxable income to zero. Plus, our cost segregation study allowed Slocomb to have a net operating loss for the current year. Now, he can carry those losses into upcoming tax years and reduce the amount he has to pay to the IRS in the future as well.
How Much Does It Cost to Do a Cost Segregation Study?
For properties that are the same size as Slocomb’s property, a cost segregation study can cost $2,000 to $5,000. At large properties, the study may cost $10,000 to $15,000. If you own a single-family residence, it might not make sense to pay for a cost segregation study.
In most cases, the cost of the study is easily covered by your tax savings. Once you begin real estate investing, you can improve your cash flow using cost segregation. One of our clients has used this technique for the last four or five years. As a result, their cash flow has improved significantly. Even though he has already owned the property for a few years, we were able to go back in time, do some legwork and finish a cost segregation study.
If you bought the property several years ago, there are a few things you will need in order to take advantage of cost segregation. The IRS will want to see proof that your property had the carpets, appliances or other features you plan on depreciating. If you have pictures or documentation of these features, you should be able to use cost segregation.
Who Can Use Cost Segregation?
Whether you prefer active investing or passive investing, cost segregation can help you save money. In general, cost segregation makes more sense if you own a rental property or invest in commercial real estate. These studies can cost anywhere between $2,000 to $15,000 to carry out. Because of this, it may not make sense to pay for a cost segregation study if you only have one rental unit.
If you have multiple units, cost segregation can help you achieve a major reduction in your federal income taxes. This technique works better if your company is generating substantial income. If you are not bringing in a lot of income, the tax savings will not equal the cost of the study.
Once you begin investing in rental properties or other passive investments, you can immediately start using a cost segregation strategy to lower your tax bill. You can conduct a cost segregation study as soon as you have remodeled, built or bought a new property. If you want to maximize your tax benefits, you should use this technique within the first year of buying the property. As long as you have the right documentation, you may be able to take advantage of this technique years later as well.
As a passive investor, it is important to find ways to increase your profitability. Other than finding new investments, you also need to search for ways to save money on your expenses. Through cost segregation, we can effectively lower your tax bill. Depending on your circumstances, you may be able to eliminate your tax bill this year and carry over your operating losses to the future as well. For properties like Slocomb’s units, it is possible to reduce your tax bill to zero for multiple years.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.