Cost segregation is a tax strategy that allows real estate investors who have acquired, built, or purchased real estate property to reduce their taxable income by having a ‘cost segregation study’ or a ‘segregation analysis’ completed on the property.
To understand how this is done we need to know what 1245 and 1250 property’s are.
1245 property is known as “tangible” or “personal” property. Personal property does not include a building or any of the structural components of a building. A few examples of 1245 property include furniture, fixtures & equipment, carpet, decorative light fixtures, and electrical costs that serve telephones and data outlets.
1250 property is generally described as “real property,” and it has further been defined as “all depreciable property that is not 1245 property”. When the term real property is used, it generally means the structural components of a building including the exterior walls, windows, floors, stairs, elevators, doors, roof, fire protection systems, plumbing, electrical, heating, ventilating and air conditioning systems, as well as other assets in the building that are permanent in nature.
There are many instances where one could justify an item being categorized as personal property as opposed to real property. It is important to have assistance from a professional to segregate between the costs of your building for depreciation purposes.
So How Does A Cost Segregation Study Work?
A cost segregation study is performed by a professional who has experience in architecture, construction, engineering, and tax accounting. This professional will conduct a formal cost segregation analysis. They will separate 1245 items from 1250 items, as listed above.
When it comes to investing in multi-family real estate, investors want to take every measure to increase their returns. One of the best ways to do this is to reduce their income tax liability via cost segregation. Cost Segregation speeds up the rate in which investors can claim tax deductions. While in a general multi-family deal there is an IRS depreciation of 27.5 years. Other commercial real estate has a depreciation of 39 years. Cost segregation allows investors to take their deductions between a 5, 7 or 15-year period increasing cash flow.
For example, an apartment worth $3M is normally depreciated over 27.5 years. With this depreciation period investors would take $109,090 deduction per year. Now imagine the investor taking the depreciation over a 5-year period, the investor would be able to depreciate $600,000 per year! It’s very unlikely the entire building would take this deduction, but the example shows how a cost segregation can provide accelerated tax deductions to maximize investor profits.
What Type of Real Estate Investor Needs to do a Cost Segregation Study?
A cost segregation study can cost upwards of $4K-$6K, so it’s important to know if you can benefit from one and that it’s worth it for you. They are mostly for commercial real estate investors or rental property owners that have significant real estate activity and would benefit from a notable reduction in their federal income tax rate. If a business is not generating substantial income, then the analysis may cost more than the savings and is not right for you.
As another example, a taxpayer purchased an apartment building in 2019 for $4 million, and a cost segregation study classified $200,000 of that amount as 5-year personal property. The taxpayer could deduct $150,000 in that year. At a 35% tax rate, this would lead to a $70,500 reduction in the taxpayer’s federal income tax liability.
Cost segregation can be an extremely effective way to reduce investor tax liability and it is every multi-family investor’s prerogative to utilize it to maximize their returns. Be sure to discuss with your tax advisor and an experienced cost segregation company to discuss if this is a good strategy for your investment.