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. In order to take advantage of this strategy, a professional ‘cost segregation study’ or a ‘segregation analysis’ should be completed on the property.
In order to understand the process, it is important to know the definition of 1245 and 1250 properties.
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 includes 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. These elements include the exterior walls, windows, floors, stairs, elevators, doors, and roof. Real property also includes permanent elements such as fire protection systems, plumbing, electrical, heating, ventilating, and air conditioning systems, and 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 essential to have assistance from a professional to differentiate 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. This professional study enables the rate of tax deduction on portions of the property to be accelerated. 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, let’s consider that value of $3M that would normally be depreciated over 27.5 years. With this depreciation period, investors would only be allowed a $109,090 deduction per year. Now imagine the investor taking the depreciation over a 5-year period. They would be able to depreciate $600,000 per year! This example shows how 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 is expensive, so it’s important to assess its value for your situation. It’s mostly for commercial real estate investors or rental property owners with significant real estate activity. If a business isn’t generating substantial income, then the analysis may cost more than the savings and isn’t recommended.
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 is an effective way to lower investor tax liability. Multi-family investors should use it to maximize returns. Consult with your tax advisor and an experienced cost segregation company to determine if it’s a good strategy for your investment.