What is Cost Segregation
Savvy real estate investors take advantage of opportunities to minimize their tax liability. One way to do this is through cost segregation — a tax planning practice that reduces taxable income by accelerating depreciation.
Depreciation involves deducting the value an asset loses over time due to wear and tear from average use. Under the General Depreciation System (GDS), residential properties depreciate over 27.5 years, and commercial properties depreciate over 39 years. While most real estate depreciates as a whole, cost segregation can speed up the process for certain components of the property.
Whether you invest in a residence or an office, the building includes more than just the structure itself. It also has plumbing, lighting, carpeting and many other features that make it usable. These assets would depreciate over five, seven, or 15 years when purchased separately. However, they are typically included as part of the property acquisition and not independently after investing.
Real estate investors can speed up the depreciation timeline for certain building components by performing a cost segregation study on the property, reducing their tax liability.
How Does the Cost Segregation Process Work?
A cost segregation study aims to identify all property costs that can be depreciated over five, seven or 15 years. Some items that may qualify include:
- Lighting fixtures
- Electrical system
- Storage tanks
- Special plumbing
- Ventilation system
A cost segregation study should be completed by a specialist or team of specialists who have the construction, engineering and tax experience to decide how to categorize different building components and how much each element costs on its own. The specialists will review inspection reports, blueprints, property records and cost details to make their determinations.
The best time to conduct a cost segregation study is during the year in which you acquire the property. Performing your study shortly after investing in the property can help you receive the maximum tax benefits. However, you can perform a look-back study after the first year and claim write-offs without amending previous tax returns.
Benefits of Cost Segregation
Segregating the costs of a property can provide significant long-term savings, but they may not be from everyone. Cost segregation studies can be expensive — usually around $10,000 to $15,000 — so they're typically used by rental property owners or commercial real estate investors with significant real estate activity.
If your investment doesn't generate enough money to offset the cost segregation study's price, it may not be the right choice. Potential cost savings are highest for real estate investors with significant property investments. Cost segregation can potentially lead to tens of thousands in tax savings for those parties.
If you believe you could benefit from a cost segregation study, it's essential to work with qualified professionals who will conduct the study in accordance with current IRS standards.
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