Ask a Real Estate CPA: What is Cost Segregation and how can it help my business?

Great question! Most real estate investors know too little about cost segregation to capitalize on its benefits, which is a shame as they could be missing out on significant tax savings opportunities. Simply put: cost segregation is a tax strategy that allows real estate investors to accelerate depreciation deductions, substantially reducing taxes owed.

What is Cost Segregation?

Let’s get into it a little more. Cost segregation is a process that breaks down the costs of a real estate investment into shorter depreciation periods. Generally, commercial and residential real estate investments are depreciated over 27.5 and 39 years, respectively, allowing for only 1/27.5 (3.64%) or 1/39 (2.56%) depreciation per year.

Cost segregation allows investors to reclassify certain components of the property to shorter depreciation periods, typically 5, 7, or 15 years. By doing so, the investor can take advantage of accelerated depreciation deductions, which can significantly reduce tax liability.

Benefits of Cost Segregation for Real Estate Investors

There are several benefits to cost segregation for real estate investors, including:

1. Increased Cash Flow – Reducing tax liability via accelerated depreciation deductions often increases cash flow. For example, a cost segregation study that results in $100,000 of additional depreciation deductions can save an investor up to $35,000 in taxes (assuming a 35% tax rate).
2. Improved ROI - Increased cash flow can lead to improved returns. When investors reinvest tax savings into their properties, property valuations and income both increase.
3. Reduced Recapture Taxes - When an asset sells, investors may be subject to recapture taxes on any accelerated depreciation deductions taken during their ownership of the property. However, with cost segregation, the amount of accelerated depreciation deductions taken is reduced, which can lower recapture taxes.

How Does Cost Segregation Work?

To take advantage of cost segregation, real estate investors must conduct a cost segregation study. This study is typically performed by a qualified real estate CPA or cost segregation specialist who analyzes the property's components and identifies those that can be reclassified to shorter depreciation periods.

The real estate CPA creates a report outlining the components that have been reclassified and their new depreciation periods. This report can then be used to claim accelerated depreciation deductions on the investor's tax return.

Additionally, when a sponsor performs a cost segregation study, passive investors benefit as well, regardless of whether they’re participants in a syndication or a fund.

What About Bonus Depreciation?

The Tax Cuts and Jobs Act of 2020 bumped the option of “bonus depreciation” up to 100%, allowing investors to depreciate up to 100% of properties with a useful lifespan of less than 20 years. The act also allows costs to be fully deducted in their first year of ownership, even if the asset is purchased used. The result is what’s considered a “paper loss” that can be used to offset the purchase cost of the asset or offset prior passive income.

Is Cost Segregation Right for You?

While cost segregation can be a powerful tax strategy for real estate investors, it may not be right for everyone. Generally, cost segregation is most beneficial for investors who own commercial, self storage, or multifamily properties with a cost basis of $500,000 or more. However, every real estate investor's situation is unique, and it's important to consult with a real estate-specific accountant to determine whether cost segregation is right for you.

If cost segregation is an option for you, then consider looking into it sooner rather than later as 100% depreciation is set to start phasing out in 2023.

Bottom Line

Cost segregation is a tax strategy that allows real estate investors to accelerate depreciation deductions, resulting in significant tax savings. By reclassifying certain components of a property to shorter depreciation periods, investors can increase their cash flow, improve their ROI, and reduce their tax liability. If you're a real estate investor with a portfolio of residential or commercial properties, cost segregation may be a powerful tax strategy for your business. Consult with a real estate-specific accountant to determine whether cost segregation is right for you.

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