Legal Research

Cost Segregation: A Tax Planning Strategy That Accelerates Depreciation

A cost segregation is a tax planning strategy that accelerates the depreciation of certain asset components of a larger real estate transaction. For investors who focus primarily on real estate, the potential tax benefits are rather substantial and result in upfront cash flow from a reduced yearly tax burden. Without cost segregation, single-family and multifamily real estate are depreciated straight-line over 27.5 years and commercial real estate over 39 years. In contrast, with a cost segregation study, certain asset components can be “segregated” from the larger asset purchase for the purpose of accelerating depreciation – in effect, reclassifying 27.5-year property into shorter-term lives that still meet IRS regulations.

Below are a few examples of components typically found in multifamily that are eligible for cost segregation depreciation:

Item Asset Class New Life
Parking lot Land improvements 15 years
Lawn sprinklers Land improvements 15 years
Lighting Furniture and fixtures 7 years
Carpeting Distributive trades & services 5 years
Kitchen stove Distributive trades & services 5 years

 

Let’s look at a practical example of how this $1,000,000 multifamily property would look from a tax perspective when pairing it with cost segregation. If you purchased the above multifamily in January 2020 for $1,200,000. If you carve out $200,000 for land, the remaining $1,000,000 will be depreciated straight-line over 27.5 years. If it has eleven units renting at $1,500/month each, here’s what your numbers might look like:

    • $198,000 per year in gross rent
    • $42,000 per year in operating expenses (maintenance, advertising, taxes, vacancy, landscaping, etc.)
    • $58,000 per year in interest on the loan
    • Net operating income is $98,000

When calculating your taxes, you would also get a depreciation deduction of $36,364. This leaves you with $61,636 in passive income for this property. Presuming you’re a high-income earner in the 37% tax bracket for the 2020 tax year, that means you would pay $22,805 in taxes on this passive income. Conversely, if you do take advantage of cost segregation, you can pick up an extra $84,952 in deductions.

These additional deductions can wipe out your passive income of $61,636 and save you the $22,805 in taxes. The remaining unused $23,316 carries forward and will offset passive income in future years until it’s used up. The tax savings in the first five years of this property provide $114, 025 in additional cash flow to roll into another property to continue creating wealth through rental investing.

It is important to note, though, that just because you have these excess deductions doesn’t mean you can use them right away to offset other non-passive income (W2 income, S corp or other business income, and so on. This is  Unless you can qualify as a Real Estate Professional (link in site to REP article I’ll be writing).

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