Expert American CPAs Navigating Complex Real Estate Tax Matters
COST SEGREGATION
26 U.S. Code § 1250 vs 1245 - Accelerated Depreciation
ON AVERAGE, 25% OF THE PURCHASE PRICE IS AN IMMEDIATE DEDUCTION.
That’s $250K on a million-dollar property and $2.5MM on a ten-million-dollar property!
Tax Strategy for Real-Estate Owners
Accelerated Depreciation - Cash is King!
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Do you own a property used in business?
Planned or performed any renovations?
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Overview of Cost Segregation:
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Cost segregation is a tax planning strategy used by real estate owners to accelerate their depreciation deductions and reduce their tax liabilities. It involves identifying and reclassifying certain building components and assets as personal property or land improvements, which have shorter depreciable lives than the building itself.
The idea behind cost segregation is that by separating out these shorter-lived assets, the owner can depreciate them more quickly, which results in higher tax deductions in the earlier years of the property's life. This can provide significant tax savings and increase cash flow.
The cost segregation process involves a detailed analysis of a property's construction and asset components, typically conducted by a qualified cost segregation specialist. The specialist will identify and assign costs to various property components, such as electrical and plumbing systems, flooring, lighting, and landscaping, to determine their respective useful lives for depreciation purposes.
Cost segregation is particularly valuable in the current tax landscape, with changes to STR laws and the past five years of bonus depreciation at 100%.
This tax planning strategy can result in significant tax savings for commercial properties, such as office buildings, warehouses, and hotels. Additionally, residential rental properties may benefit from cost segregation if they meet certain criteria.
The current value of cost segregation is at a premium, making it an increasingly popular tax strategy among real estate investors.
A BAY cost-segregation specialist can help to determine whether a cost segregation study is the right strategy for you today!
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STRs can provide unique tax advantages for some owners.
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Unlike long-term rentals, which are considered passive activities for tax purposes, short-term rental properties can be considered non-passive activities if one of the following tests are met:
1) The average period of customer use for such property is seven days or less.
2) The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers.
This means that if you have losses from a short-term rental, and materially participate in the activity, you can use those losses to offset non-passive income (e.g. W-2 or 1099 income) without needing to qualify as a real estate professional.
SHORT-TERM RENTAL
RESIDENTIAL
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Most CPAs will depreciate an entire real estate investment over 27.5, or 39 years. A Cost Segregation study will allocate as much of the purchase price as possible to asset categories with much shorter lives.
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Commercial property is the most common property for cost segregation. Commercial real estate investors should always consider cost segregation in their strategy.
COMMERCIAL
NOTICE - CHANGE OF BONUS DEPRECIATION :
Tax Cuts and Jobs Act, personal property placed into service after 9/27/17 through 2022 are eligible for 100% bonus depreciation. 2023 is an 80% bonus depreciation year. The date the asset (building) was placed in service locks in the bonus depreciation rate.
NOTICE - IRS REQUIREMENTS - DIY AND CORNER CUTTING - NOT UP TO CODE:
The IRS is advising taxpayers of a rise in DIY Cost Segregation. According to the IRS Cost Segregation Audit Guide, Cost Segregation MUST be done by a qualified third party. Don’t get scammed. See below guidance from the IRS.
“An [IRS] examiner should view this approach with caution since it lacks sufficient documentation to support its allocation of project costs.
In addition, an underlying assumption is that the study is performed by “qualified individuals” and professional firms” that are competent in design, construction, auditing, and estimating procedures relating to building construction.”
Frequently Asked Questions (FAQS)
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A cost segregation study can be beneficial for real estate owners at various stages of property ownership, including during the acquisition, construction, renovation, or sale of a property. However, the optimal time to conduct a cost segregation study may depend on several factors, including:
Property size and value: For smaller properties, the cost of a cost segregation study may outweigh the potential tax savings.
Tax liability: If a property owner has a high tax liability, they may benefit more from accelerating their depreciation deductions through cost segregation.
Property age: If you have owned a commercial building for 20 years, it is halfway through its depreciation life, and thus the cost segregation will provide half the benefit.
Future plans for the property: If a property owner plans to hold the property for two years.
Before improvements or renovations: If a property owner plans to make significant improvements or renovations to their property, a cost segregation study will be particularly valuable, as it can help to identify shorter-lived assets that can be written off when removed, and depreciated more quickly when installed.
In summary, the decision to conduct a cost segregation study should be based on a careful evaluation of the property, the owner's tax situation, and their future plans for the property. A BAY cost segregation specialist can help to determine whether a cost segregation study is the right strategy for a particular property owner at a particular time.
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Key benchmarks for strong Cost Segregation Studies.
Plan to hold the property for 3 years (depreciation recapture)
The cost of doing the study has a positive ROI
Making a Net Profit, Taxable liability to offset
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Our Cost Segregation Studies start at $10,000 per property.
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A secondary goal of Cost Segregation is to establish the depreciable tax value for each major building component that is likely to be replaced in the future. Examples include roofs, windows, doors, bathroom fixtures, HVAC, etc. When a component is replaced, taxpayers are able to claim a “retirement loss” or “partial disposition” deduction for its remaining depreciation, assuming the value was previously established.
When you buy a property with plans to make improvements, it is best to conduct a Cost Segregation study as soon as possible. This will establish a baseline value for the components of the property, allowing you to identify and deduct the basis of anything you replace.
An example:
You buy a $1.2MM house and renovate the kitchen for $70K. During the renovation, you take out $40K worth of cabinets, flooring, and appliances. Having already completed a Cost Segregation study, you are able to take an immediate “retirement loss” deduction for $40K, and the $70K of capital expenditures can be classified appropriately.
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A Cost Segregation study can be completed any time after a property's purchase, remodel, or construction. However, engaging a Cost Segregation team during development can provide significant benefits, including helping gather the necessary documentation needed to pursue all available tax deductions, and consulting on the tax implications of comparable building decisions.
Document Collection: Having our team available during construction can ensure contractor documentation is up to standard, which can often support larger deductions.
Consulting: Minor construction decisions can often have significant tax implications. LVT vs tile flooring are often both great options for your property. Tile flooring, however, has to be depreciated over the life of your building, while the full cost of your LVT flooring can be taken as a year-one deduction.
Having a team of CPAs available during construction can provide valuable insight into how decisions will impact taxes and cash flow.