Commercial building qualified for a cost segregation

Real Estate Owners Ultimate Guide to Increasing Cash Flow

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As an investor in commercial or residential real estate, you’re always seeking a financial edge. Property expenses, including regular maintenance, renovations, and expansions, can add up quickly. And you likely need working capital for future investments. That’s why finding ways to maximize your financial position is crucial. One powerful strategy for reducing your tax liabilities and increasing your cash flow is through cost segregation.

What is Cost Segregation in Real Estate?

Cost segregation is a tax-saving strategy that allows investment property owners to accelerate their depreciation deductions. By sorting your property’s components into separate asset classes with depreciation lives of five, seven, or 15 years (as opposed to 39 years for commercial property and 27.5 years for residential property), you can significantly reduce your income tax burden and increase cash flow. The IRS plays a crucial role in the tax process by setting the guidelines for asset classifications and bonus depreciations. Experienced engineers and tax professionals are typically hired to perform cost segregation studies on behalf of investment property owners and their CPAs.

How Cost Segregation Studies Work

To benefit from cost segregation, a detailed study is required to uncover ways to unlock bonus depreciation and maximize tax deductions for your investment property. It’s important to engage a financial firm with proven expertise in engineering, tax law, and accounting to advise and assist.

While there is no set formula for conducting a cost segregation study, four key steps are commonly followed:

Step 1: Feasibility Analysis

This critical first step involves a detailed examination of your investment property to determine its eligibility for cost segregation. Various property components will be spotlighted such as plumbing fixtures, electrical systems, and even driveways. They’ll then be assigned to distinct asset categories that are eligible for accelerated depreciation.

Step 2: Gathering Information

To accurately assess the value and depreciation potential of your property, substantial documentation will be needed. From property appraisals to closing documents, each piece of information helps paint a clearer picture of your real estate investment, laying the groundwork for a successful study.

Step 3: Property Analysis

Once all the relevant data is gathered, a detailed examination of your property will be conducted. This is when specific assets are identified to accelerate depreciation. Be sure to provide your chosen preparer with key property documents including inspection reports, property records, and blueprints. 

Step 4: Report Preparation

Upon completion of the analysis, a comprehensive report is then drafted. This document serves as your roadmap to understanding and implementing the cost segregation strategy, detailing the accelerated depreciation schedules and projecting your tax savings.

Cost Segregation Analysis Example

Let’s consider a multifamily property with a total acquisition cost of $5m. If we subtract land allocation, assuming 20%, your taxable basis becomes $4m.

Using the standard 39-year depreciation formula, your annual depreciation deduction would be $102,564.  At a 35% federal income tax rate, this would translate to yearly tax savings of approximately $35,897 over the 39-year depreciation period.

However, a cost segregation study could reveal the potential for 20-30% accelerated depreciation in the first year using 100% bonus depreciation.

This approach allows for the segregation of specific components into categories of assets with shorter lifespans of 5, 7, and 15 years.

For example, you might be able to depreciate $600,000 of personal assets (flooring, cabinets, appliances, etc) over 5 years and $200,000 spent on land improvements (fencing, paving, landscaping, etc) over 15 years.

This would effectively revalue your property at $3,200,000, with the assets eligible for accelerated depreciation valued at $800,000.

With this detailed breakdown, you can accelerate depreciation claims to reduce your taxable liability. In the first year following your cost segregation study, you could claim depreciation deductions of approximately $82,051 for the property, including $600,000 for personal assets (depreciated over 5 years) and $200,000 for the exterior improvements (depreciated over 15 years).

Assuming a tax rate of 35%, this strategy could yield first-year tax savings of around $308,718, significantly more than the $35,897 savings realized without a cost segregation study.

Cost Segregation Pros and Cons

Although cost segregation offers many advantages for real estate investors, there are downsides as well. Here’s a closer look at some important pros and cons to consider as a rental property owner before investing in a study.

Pros

Cost segregation serves as a financial lever, offering relief and flexibility in managing your real estate investment, ultimately enabling more aggressive expansion or development strategies. It allows you to:

Reduce Tax Liabilities
Accelerating depreciation deductions directly lowers your taxable income, resulting in significant tax savings.

Increase Cash Flow
The immediate tax savings enhance your liquidity, providing more cash on hand for operational needs or unforeseen expenses.

Reinvest in New Opportunities
The additional cash flow can be strategically reinvested into expanding your real estate portfolio or improving existing properties, driving further growth.

Cons

While the benefits of cost segregation are compelling, there are two main considerations to keep in mind:

Cost
Engaging in a cost segregation study requires an upfront investment. It’s important to weigh the potential tax savings against the cost of the study to ensure it’s a financially sound decision.

Time
The process typically takes one month to complete. This time investment is necessary to ensure a thorough and accurate analysis, but it’s something to plan for in your overall investment timeline.

Conclusion

As a real estate investor, cost segregation is a powerful strategic tool you can use as part of your tax planning process to significantly enhance your cash flow. By accelerating depreciation on certain property components, you can reap substantial tax savings and free up capital for reinvestment. 

And the best news of all? Expert guidance is available. Omega Accounting provides comprehensive cost segregation studies that are fully compliant and IRS-defensible.

Ready to get started? Contact us for a free consultation.

Cost Segregation FAQs

Cost segregation can be complex. Here are some common questions that real estate investors have about this tax credit strategy.

How long will it take to complete the study
The duration of a cost segregation study varies depending on the complexity of your property but generally takes three weeks to two months with Omega.
What is involved in a cost segregation study?
A cost segregation study involves a detailed analysis of your property to identify and reclassify assets for accelerated depreciation, presented in a clear and well-documented format.

Omega’s process for conducting detailed cost segregation includes:

Property Examination: A thorough examination of the property, by an accredited engineer, is conducted to identify components that can be reclassified into shorter depreciable lives than the building itself.

Component Identification: Components of the property are identified based on their function and classification. These components may include HVAC systems, plumbing, electrical wiring, carpeting, lighting, landscaping, etc.

Cost Allocation: The costs associated with each identified component are allocated separately from the overall property cost. This often involves reviewing construction drawings, invoices, and other relevant documentation.

Depreciation Reclassification: Once the components are identified and their costs allocated, they’re reclassified into appropriate asset classes with shorter depreciable lives, typically 5, 7, or 15 years, instead of the standard 27.5 or 39 years for residential and commercial buildings, respectively.

What should I consider when selecting a cost segregation provider?
Look for a cost segregation specialist like Omega, with a robust track record, specialized expertise in both engineering and tax law, and a clear understanding of IRS guidelines, including the IRS Cost Segregation Audit Technique Guide (ATG).
Will the company be available if I get audited by the IRS?
There’s a big difference between preparing a cost segregation study and standing by one. It’s very important to choose a provider that offers post-study support, including assistance in the event of an IRS audit. 

Omega has a 15+ year track record of providing fully compliant, IRS-defensible reports for hundreds of clients.

How long do I need to hold on to the property for cost segregation to make sense?
While the tax benefits are more immediate, holding your property for at least three to five years prevents any depreciation recapture when the property is sold, making it a worthwhile investment.
Cost Segregation Expert, Isaac Downing
Issac Downing Senior Director of Tax Incentives Tax industry expert, leading the expansion of Omega’s Credit & Incentives offerings, Downing has more than 15 years’ experience in cost segregation, playing every role from conducting engineer-driven studies to driving business growth. Downing holds a BS, Accounting & Finance, and with his extensive experience in public accounting and tax management, he has saved clients hundreds of millions of dollars in tax credits and incentives.