- The Benefits of Cost Segregation for Accelerated Depreciation
- What is Cost Segregation for Accelerated Depreciation?
- How Cost Segregation for Accelerated Depreciation Works
- Is Cost Segregation Right for My Business?
The Benefits of Cost Segregation for Accelerated Depreciation
Clients often ask us about the benefits of cost segregation for commercial office buildings, bonus depreciation, and other methods to minimize their tax liability. Using cost congregation for accelerated depreciation is one of the methods savvy commercial real estate investors use to limit their taxable income. Commercial real estate depreciation can be confusing, but you can amplify the depreciation on an office building by closely following the updated tax codes.
Here’s a quick video from our friends at The Anderson Group explaining cost segregation for accelerated depreciation.
What is Cost Segregation for Accelerated Depreciation?
First, let’s define some of the terms we’re talking about here:
In real estate, depreciation refers to the loss of an asset’s value over time. Most real estate suffers from normal wear and tear over the years, making it less valuable as it ages. Therefore, the IRS allows commercial property owners to deduct those losses from their overall tax burden.
How do we calculate depreciation? Like most things pertaining to taxes, the IRS has guidelines about depreciation, and property owners must adhere to those guidelines. The “useful life” of your property determines the depreciation value. The type of property you own determines its useful life.
Residential Real Estate Depreciation
Most commercial real estate property owners invest in residential real estate. Residential real estate is any property where tenants live – townhomes, apartments, condos, or single-family properties. If a tenant lives and sleeps in the property, but pays rent to live there, it’s likely considered residential.
Per the IRS tax code, residential real estate has a “useful life” of 27.5 years. Therefore, to determine the depreciation value of your property, you would divide your cost basis by 27.5, and deduct the remainder as your annual depreciation.
Commercial Real Estate Depreciation
Commercial properties, defined as anything used to manufacture or sell goods and services, have a longer “useful life” according to the IRS. Commercial real estate depreciation is calculated based on a 39-year useful life. Like residential depreciation, owners calculate this total by dividing the cost basis by 39 and using that amount to lower the annual tax burden.
Cost segregation is a tax strategy that converts traditional depreciation into an asset-based depreciation. This strategy can accelerate the depreciation rate, therefore lowering the owner’s annual taxable income.
How Cost Segregation for Accelerated Depreciation Works
Thanks to the Tax Cuts and Jobs Act of 2017, real estate owners can now accelerate the depreciation of their properties, therefore reducing their annual tax burden each year.
Step 1: Contact a Tax Expert
It’s important to contact an expert real estate tax specialist or accountant to discuss cost segregation and accelerated depreciation. If done improperly, this could become an IRS tax nightmare. Before moving forward, consult with the professionals to determine if this method is right for your investment strategy.
Step 2: Conduct a Cost Segregation Study
In order to qualify for accelerated commercial real estate depreciation, you must have a cost segregation study done. These studies will identify real property and assets – that is, assets that aren’t the building themselves and personal property – and assign depreciation values to those items.
These studies can be very costly, so you’ll have to weigh the costs and benefits of transferring your property to an accelerated depreciation category.
If possible, investors should have a cost segregation study done as soon as they purchase, build, or renovate a property. To realize maximum tax benefits, the owner must have this study completed within one year of purchase. The new tax laws passed in 2017 allow owners to deduct 100% of asset costs from their taxable income during the first year of ownership. This deduction, known as “bonus depreciation,” can significantly reduce the amount you’ll owe on a commercial property.
However, we should note that this first-year bonus depreciation is only valid until 2022, and will phase out completely by 2027.
Step 3: Use the Cost Segregation Study to Lower Taxable Income
Once the cost segregation study is complete, you can use these assets to offset your taxable income.
As an example, let’s look at depreciation on an office building, and how cost segregation for accelerated depreciation would apply.
If you purchase an office building for $10 million but don’t conduct a cost segregation study, your depreciation rate would be the cost basis (the total purchase price, minus other considerations) divided by 39. If we assume the cost basis for this property is $9 million, the annual depreciation on an office building would be roughly $230,800 annually.
However, let’s say you conduct a segregation study which determines that 10% of the property’s assets are “personal property” (items that could be removed from the property). Those assets have much shorter useful life spans. So, assuming $1 million of that $10 million office building is “personal property,” you can claim the $1 million as bonus depreciation. Therefore, you can write off these assets during the first year, significantly reducing the overall tax burden.
Additionally, these assets depreciate faster than real estate as a whole. Most assets have a “useful life” of as few as five years, depending on the segregation study findings. Therefore, the annual tax burden and depreciation of these office buildings is magnified. This method could save tens or even hundreds of thousands of dollars per year.
Is Cost Segregation Right for My Business?
As we mentioned above, cost segregation can be incredibly beneficial for investors. However, cost segregation studies are expensive, and they won’t be the best move for every commercial real estate investor.
For more details on accounting and depreciation strategy check out our article: Accounting and Bonus Depreciation for 2019
Consult your real estate tax advisor or accountant to determine if cost segregation is best for your business.