Investing in commercial real estate comes with a number of advantages and one of them is significant tax savings. Real estate investors are able to reduce their tax burden through the depreciation maximization concept known as cost segregation. In this article, we shall define what cost segregation is and the potential benefits that real estate investors get by conducting a cost segregation study when undertaking commercial real estate investment projects.
What is cost segregation?
Cost segregation is an accelerated depreciation technique that real estate investors use to get incredible tax benefits when depreciating assets over their useful life. As a strategic tax planning tool, investors use the cost segregation concept to divide a real estate property into various sets of depreciable categories that allow the real estate property to be depreciated much faster instead of using the ordinary 39-year period.
How does cost segregation work?
When real estate investor wants to use the cost segregation technique, they view the purchase of a real estate property as a set of building components instead of one structure. The IRS also views a real estate property as a combination of different components.
Although a standard real estate property structure has a recommended depreciation period of 39 years for commercial and 27.5 years for residential properties, the IRS provides some flexibility for some real estate property components (20-40%) to be depreciated faster over a period of 5, 7 or 15 years.
A real estate investor starts by commissioning a “cost segregation study” whose objective is to carefully evaluate the status of every key component of the property. Common real estate property components include; land, any land improvements, the roof, HVAC systems, appliances, flooring, cabinetry, and countertops. These components once reviewed are then segregated individually so that they can undergo accelerated depreciation at different rates.
Tax benefits of cost segregation
The main reason why real estate investors utilize the cost segregation technique is to help them in tax savings and planning. It enables investors to accelerate depreciation of some components of the property in the first few years of ownership thus, saving them huge tax burdens that could have been carried on over many years.
The cost segregation strategy is right for commercial real estate investors who invest in capital-intensive real estate projects and are looking for ways to reduce their tax liability burden.
Cost segregation works well for real estate investors who invest in commercial real estate syndications. Under real estate syndication strategy, commercial real estate investors partners with reputable real estate firms to buy and manage real estate properties. The role of the real estate investor in such a scenario is to provide the much-needed investment capital required to purchase the commercial real estate property.
On the other hand, the real estate firm will be charged with the responsibility of professionally managing the property and ensuring that depreciation tax deductions are maximized to the limits allowed by the IRS.
Accelerated depreciation through a cost segregation strategy ensures that the tax liability on the commercial real estate property is significantly reduced while investors enjoy increased cash flow from the income generated by the commercial real estate property.