Higher profitability, lower tax liability, and increased cash flow are the three primary factors which make cost segregation so important. In addition, lower taxes and increased cash flow mean plans for the business can be crystallized and implemented more easily. Cost segregation is, therefore, part of the bedrock of success for real estate investors and developers.
Cost Segregation in Practice
Constructing, renovating, remodeling, and acquiring real estate for commercial use typically result in depreciating those assets over a 27.5- or a 39-year period. The timescale depends on whether they are residential (apartment blocks, single family homes, etc.) or commercial (shopping malls, hotels, warehouses, etc.)
By identifying specific, and IRS-approved, components that can be segregated from the rest of the real estate they can be allocated to accelerated depreciation categories. The three primary categories are land improvements, specific additions to the building’s core structure, and personal property. Those components may then be written off in 5, 7, or 15 years.
It is possible, therefore, to reduce income tax liability by up to $70,000 for each $1,000,000 of building cost basis owned. Specific savings are based on a detailed cost segregation analysis applying IRS-approved standards.
Making Use of Cost Segregation in Business
1. Simple Depreciation Acceleration
When a piece of real estate is constructed or acquired, there is usually a minimum time span before its value will increase enough for it to be sold at a profit. Maintaining the property generates costs; those costs should obviously be less than the corresponding income. Property and income taxes become payable. The amount of tax due is usually reduced by the 27.5- or 39-year depreciation write-off approach.
Cost segregation enables tax liability to be reduced. By shifting depreciation of approved components from 27.5 or 39 to 5, 7, or 15 years, that accelerated depreciation reduces each year’s tax liability. By reducing tax payments, cash for running costs, and capital for further investment is automatically generated. It does not have to be borrowed, attracted by exchanging company stock for new investment, or for corporate plans to be delayed.
2. Partial Asset Disposition
If the property is being renovated, then some components will be removed and replaced with new and improved components. The old and the new components will be depreciated. Unless partial asset disposition (PAD.) is taken, double depreciation of those old and new assets accumulates. This will impact recapture tax calculated at ultimate sale. By having previously segregated components into different asset classes, the recapture tax is reduced.
3. More Availability Means Greater Benefit
Cost segregation was once used, primarily, by major corporations. Today, properties with a cost basis in the hundreds of thousands as opposed to the tens of millions of dollars now qualify for accelerated depreciation. This, on its own, makes the principle both viable and important for the smaller investor or developer.
4. The Time Value of Money
A simple advantage of applying a cost segregation strategy is that money available today is worth more than ultimate profit made available at eventual disposition. By accelerating depreciation, even by a small amount on lower-value properties, cash flow improves. That cash becomes available for both running costs and for growth. When used for growth by investing in additional properties, components in those new properties can also be subject to accelerate depreciation, thus magnifying the benefit.
5. Cost Segregation and 1031
Relinquishing and acquiring real estate benefits from capital gains tax deferrals when managed via a 1031 Exchange. The increased profit generated by segregating costs is not, therefore, necessarily subject to immediate taxation payable on sale. All the tax can be deferred.
Personal as well as corporate investors can, by making use of The Tax and Jobs Act legislation, eventually avoid paying that tax if, when they move out of active property ownership, they reinvest in approved development zones. After an amount of time, the deferred tax is forgiven. The benefits of cost segregation can, therefore, be “held” indefinitely, and the benefits of recent legislation are increased.
The Takeaway
Cost segregation is important. It enables a business’s profit to increase and cash flow to improve by accelerating the depreciation on real estate components. The immediate and long-term benefits make it a crucially important strategy for real estate investors and developers. Completing cost segregation analyses correctly and to IRS standards demands competence in specific areas of real estate, and experience in tax law. To discuss how you can make use of this strategy, please click here to contact us.