What Is Cost Segregation in Real Estate Investing?
Cost segregation is a strategic tax planning tool that allows investors in real estate to maximize their depreciation deductions by identifying and reclassifying personal property assets. This process involves an in-depth analysis of the costs associated with the acquisition, construction, or renovation of a property.
By segregating these costs, investors can accelerate depreciation deductions, reduce taxable income, and enhance cash flow. This technique is particularly beneficial in the realm of commercial real estate, where the scale of investments can lead to significant tax savings. Cost segregation and cost segregation studies are just one example of private-market real estate potentially offering compelling tax benefits, unique to the asset class. (Note that EquityMultiple does not provide tax advice; investors are encouraged to consult with a tax professional when making investment decisions.)
This article takes a close look at cost segregation in real estate investing practice, and how individual passive investors may be able to tap in.
Cost Segregation Definition
The strategy of separating cost line items for the purposes of maximizing after-tax returns of an investment. (A commercial real estate investment, for example.)
Understanding the nuances of cost segregation is crucial for accredited investors looking to optimize their after-tax returns when investing via a platform like EquityMultiple. Cost segregation is a tactic that, when executed correctly, can markedly improve the take-home profitability of a real estate investment.
This article takes a look at the cost segregation concept, and what passive real estate investors should be aware of.
How Do Sophisticated Investors Use Cost Segregation?
Cost segregation is a powerful tool that allows commercial real estate investors to accelerate depreciation deductions for certain components of their properties. Instead of depreciating the entire property over the standard 27.5 or 39-year period, cost segregation allows you to break down the property into shorter-lived assets such as personal property, land improvements, and even specific building components. This has several key benefits:
- Reduced Tax Liability: By front-loading depreciation on shorter-lived assets, you can significantly reduce your taxable income in the early years of ownership. This can translate into substantial tax savings.
- Enhanced Return on Investment (ROI): With cost segregation, you can potentially accelerate your return on investment and improve the overall financial performance of your commercial real estate investment.
For real estate investors, particularly those involved in large-scale commercial projects, understanding and applying cost segregation can lead to significant tax advantages. By accelerating depreciation expenses, investors can defer federal and state income taxes, thereby improving their property’s cash flow in the early stages of the investment. As an individual investor, you may be able to take advantage of cost segregation while investing fractionally alongside a sponsor who is operating at such scale. (Note, please consult with a professional tax advisor as you consider real estate investments.)
In many cases, passive real estate investing allows for “pass through benefits” — the ability to capitalize on the same tax-advantaged strategies that the sponsor (the managing party) is able to realize. Note that EquityMultiple does not offer tax advice and you should always consult with a licensed tax professional when investing in real estate.
Bonus Depreciation
Bonus depreciation is another tax incentive that complements cost segregation. Under current tax laws, investors are eligible for an 80% bonus depreciation on a qualified property in the year it’s acquired. Here’s why this is valuable:
Immediate Tax Deductions: Unlike regular depreciation, which spreads deductions over several years, bonus depreciation allows you to deduct a significant portion of the property’s cost in the year it’s acquired or placed in service. This results in substantial tax savings right away.
Offsetting Other Income: Bonus depreciation can be used to offset income from other sources, potentially reducing your overall tax liability.
Increased ROI: By minimizing your tax obligations, bonus depreciation can directly boost your property’s return on investment.
Cost Segregation Study
A cost segregation study is a comprehensive analysis conducted by tax professionals or engineers to identify and reclassify personal property assets. This detailed study is essential in maximizing the tax benefits of cost segregation. It involves a thorough examination of the property, including its components and site improvements, to determine which parts can be depreciated over a shorter period.
Such studies are particularly relevant for properties undergoing significant renovations, expansions, or new construction. The IRS requires these studies to be detailed and well-documented, often necessitating the expertise of professionals who specialize in this area.
The good news for you as a passive real estate investor: you do not need to do the heavy lifting of a cost segregation study in order to benefit from cost segregation. Accredited investors considering real estate through crowdfunding platforms should seek properties where a cost segregation study has already been performed, ensuring that the potential tax benefits have been fully explored and can be utilized.
Again, it’s important to consult with a tax advisor to understand your specific situation. But this is a helpful overview of a cost segregation study.
How Does a Cost Segregation Study Work?
The process begins with ordering a cost segregation study from a financial firm with expertise in engineering, construction, tax law, and accounting. This can only be done once for a given investment property owned.
- Feasibility Analysis: The first step is to conduct a feasibility analysis to determine if the property is a good candidate for cost segregation. This involves studying the different components like plumbing, roofing, electrical systems, etc. If purchased separately, these could be depreciated over 5-15 years rather than the longer 27.5 years for residential buildings or 39 years for commercial properties.
- Gathering Information: The firm collects all necessary information like recent appraisals, inspection reports, and closing documents to determine the value of the property and its components.
- Property Analysis: The team then analyzes the property, identifying any operating costs that can be depreciated over shorter timelines of 5, 7 or 15 years based on documents like blueprints, property records, and inspection reports.
- Final Report: Finally, a report is prepared outlining how much can be saved on income taxes by using the cost segregation strategies for accelerated depreciation of certain property components identified.
Drawbacks and Considerations of Cost Segregation
While cost segregation can offer significant tax benefits, investors should be aware of several potential drawbacks and considerations:
- Upfront Costs and Effort: Conducting a thorough cost segregation study requires an initial investment of time and money. This can be significant, especially for smaller properties or businesses. Investors need to:
- Hire qualified professionals with expertise in engineering, construction, tax law, and accounting
- Locate and provide necessary documentation to specialists conducting the analysis
- Weigh these upfront costs against projected tax savings
- Regulatory Complexity and IRS Scrutiny: Tax regulations surrounding cost segregation are intricate. The IRS may review cost segregation studies to ensure compliance with tax laws and regulations. This highlights the importance of working with qualified professionals, despite the costs. Misclassifying assets or failing to comply with IRS guidelines can lead to:
- Costly mistakes
- Potential penalties
- Increased risk of audits
- Long-term Tax Implications: While accelerating depreciation improves cash flow in early years, it reduces depreciation deductions later. This could result in higher taxable income in the future, potentially affecting long-term tax planning.
- Impact on Overall Tax Situation: Accelerated depreciation can affect passive activity loss limitations. It may not be fully utilizable if the investor lacks sufficient passive income to offset. Integrating cost segregation into a comprehensive tax strategy is essential.
- Potential for Recapture: If the property is sold before the end of its recovery period, there may be depreciation recapture, potentially leading to a higher tax liability upon sale.
- Property Considerations: The benefits of cost segregation might be limited for:
- Properties held for a short duration
- Properties subject to major renovation shortly after acquisition
In summary, while cost segregation can significantly enhance the financial performance of investment properties, it’s imperative to weigh these benefits against potential risks and complexities. Consulting with a tax professional can help navigate these challenges and make informed decisions aligned with your investment goals.
For accredited investors considering real estate investments through platforms like EquityMultiple, understanding these nuances can be crucial in maximizing after-tax returns while mitigating potential risks. Notably, real estate investing platforms such as EquityMultiple often ensure that cost segregation studies are performed in advance, potentially mitigating some of the upfront costs and efforts for individual investors.
Cost Segregation Analysis: A Real Estate Example
To understand the impact of cost segregation, let’s consider a real-world example. Imagine an accredited investor purchases a commercial property for $2 million. A standard depreciation schedule without cost segregation would depreciate the building evenly over 39 years, equating to approximately $51,282 per year.
EquityMultiple’s Tax Practices
While we do not offer tax advice, we strive to bring many of the potential tax benefits of real estate investing to our investors. You can find more about our current tax practices here.
However, with a cost segregation analysis, let’s assume 20% of the property’s cost ($400,000) is reclassified to personal property with a 5-year depreciation schedule. This reclassification allows for an accelerated depreciation of $80,000 per year for the first five years, in addition to the standard depreciation on the remaining $1.6 million. This accelerated depreciation results in higher tax deductions in the initial years, thereby improving cash flow and the overall return on investment.
The graph below illustrates the power of cost segregation in enhancing the financial performance of a real estate investment. For individual accredited investors engaging in real estate through crowdfunding platforms, understanding and leveraging cost segregation can be a game-changer in terms of maximizing returns and optimizing tax strategies.
Case Study — Cost Segregation in Action
Let’s take a look at an EquityMultiple investment, Villas Tech Ridge, that underscores the potential benefits of cost segregation. Villas Tech Ridge is an LP equity investment (within the Grow pillar) that was acquired by a three-time repeat sponsor with EquityMultiple. The Sponsor’s business plan includes cost segregation, which will allow them to take 80% of the bonus depreciation the year of purchasing the Property (year 1) and the remaining 20% will be used over the life of the Property (see above). This will result in an accelerated depreciation at the investor level and potentially reduce tax liability during the targeted investment period.
You can hear more about this investment opportunity in the sponsor’s own words in the below video.
Commercial real estate investing can present many interesting strategies, but there is a lot to know. EquityMultiple’s dedicated Investor Relations Team can help you get comfortable.
Cost Segregation in Real Estate: The Bottom Line
Cost segregation is a vital tool for real estate investors, particularly in the commercial sector. Its ability to significantly improve cash flows and enhance the overall return on investment cannot be overstated. As the real estate investment landscape continues to evolve, with more individuals accessing private commercial real estate through crowdfunding platforms, the relevance and benefits of cost segregation will likely increase. Accredited investors should consider the advantages of this strategy and consult with tax professionals to fully understand and apply its principles to their investments.
It is essential to note that navigating the complexities of cost segregation and bonus depreciation requires expertise. Please note that EquityMultiple does not provide tax advice. Engaging a qualified tax advisor or specialist with experience in real estate investments is highly recommended to ensure compliance with tax laws and maximize the benefits.
Cost Segregation in Real Estate — FAQs
Q: Can cost segregation be applied to any type of real estate investment?
A: While most beneficial for commercial properties, cost segregation can also apply to residential rental properties. It is not applicable to personal residences.
Q: How much can cost segregation save on taxes?
A: Tax savings vary based on property type, cost components, and the investor’s tax situation. A professional feasibility analysis can offer precise estimates. However, savings of hundreds of thousands to millions of dollars are not uncommon, especially for larger commercial properties.
Q: Is cost segregation worth the cost?
A: Given the potential for significant tax savings, the investment in a cost segregation study often yields a high return, making it a worthwhile strategy for many investors. Returns on investment of 10 to 1 or higher are common.
Q: Can I perform a cost segregation study on a property I’ve owned for several years?
A: Yes, cost segregation can be applied retroactively, offering a catch-up on missed depreciation deductions without amending prior tax returns. This is known as a “look-back” study and can provide substantial immediate tax benefits.
Q: How do I get started with cost segregation?
A: Consulting with a cost segregation specialist is the first step. They can evaluate your property’s eligibility and guide you through the process, ensuring compliance and maximizing benefits. Many reputable firms offer free initial consultations and feasibility analyses.