A general tax strategy is to recognize as many write-offs as we can.
We want to do this as early as we can to minimize taxes. And cost segregation helps real estate owners minimize taxes. Reinvest tax savings into your growing business. Use those additional funds to invest in items that further reduce your taxes. When it comes to your tax return, this is one of the few times when losses are actually a good thing! Cost segregation is one of the most effective ways to create losses when you are a real estate investor or your business owns real estate.
What is Cost Segregation Study?
A cost segregation study evaluates the structure and components of a building. It identifies and assigns depreciable values to items that can be re-classified as personal property and depreciated over a shorter tax life (typically 5, 7, and 15 years). Such items include
Without the cost segregation study, the building depreciates over 27.5 years for residential real property. Or it can depreciate over 39 years for a commercial property.
When Should the Study be Performed?
If the cost segregation study is performed in the first year the building is placed into service, you will also be able to recognize bonus depreciation for those non-real estate assets, and fully depreciate 100% in year 1. This is regardless of how old the asset is.
What Happens if I Didn’t Do a Cost Segregation Study?
You may have missed the opportunity for cost segregation in year 1 of the property. Or maybe it didn’t make sense based on the financial picture of you and your spouse. However, you can still perform a cost segregation study in a year after it’s placed in service. You can use Form 3115 to “catch up” and claim missed depreciation retroactively. This can happen as far back as the date you placed the property in service.
Anything Else I Should Know?
Keep in mind that this article was written in January 2021, and the amount of bonus depreciation that you can recognize will be phased down by 20% each year (as of the time of this article), starting in 2023 until it is eliminated.
Nevertheless, you will be able to accelerate the depreciation of the newly identified components. Also, cost segregation helps real estate owners to maximize their depreciation write-off, which is a non-cash expense.
When used appropriately, many investors find they eliminate any tax liabilities from their investments. They also find that even cash-flow positive investments will create additional tax refunds!
Ready to Get Started?
Talk to a tax professional before implementing this strategy to see if it makes sense for you. Things to think about are other sources of income, current and future marginal tax rates, and how your losses will be treated.
If you are a real estate investor, the losses will typically be classified as passive. In general, they will not offset other sources of active income such as that from your W-2. There are several exceptions to this rule that you can take advantage of, such as, the passive activity loss exception and real estate professional tax status. Some short-term rentals and hotels may create active losses to offset other sources of income for you and your spouse.
Mark Perlberg, CPA, specializes in providing accounting solutions and advanced tax strategies to enable real estate investors and business owners to grow their businesses and achieve financial freedom. He is a real estate investor, Certified Tax Planner, Certified Public Accountant, and has a Masters in Accounting