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Cost Segregation: Pay Less Taxes on CRE Investments

A Guide to Cost Segregation In Commercial Real Estate Investing

One of the biggest areas of focus for people investing in commercial real estate is how to handle the tax implications. If investors aren’t well-versed in how to legally reduce their tax burden, they could end up paying much more than they have to. That would make their great investment a reasonable one, at best. At worst, it could mean their investment would actually cost them more than it was really worth.

When it comes to cost segregation commercial real estate investors may not have all the facts. That can cause them to miss out on opportunities to pay little to no tax on the investments they’re making. When they pay less tax they can focus on additional investments with the money they’re saving. Here’s what you need to know about multifamily financingcommercial real estate depreciation, and other cost segregation considerations in the commercial real estate sector.

What is Cost Segregation in Commercial Real Estate?

As a strategic tool for tax planning, cost segregation can shelter an investor’s taxable income on commercial properties. That occurs through commercial real estate depreciation that’s focused on specific aspects of the business and considered at an accelerated rate. In short, some components of the properties are depreciated at a rapid rate, which reduces the taxable amount the investor shows on the property.

Due to recent tax reform, there are big benefits to accelerated depreciation and cost segregation commercial real estate investors will want to carefully consider. A cost segregation study can be a good place to start when using this technique, but understanding the specifics of the strategy and what all goes into it is vital, as well. The biggest hurdle for many commercial investors is working with depreciation in a way that gives them the largest benefit.

How Depreciation Helps the Commercial Real Estate Investor

Depreciation means deducting from the value of the asset over time. The most common reasons for depreciating a commercial building are things like standard wear and tear. No building can remain perfect and looking brand new forever, and each year the building will have a little bit less value due to the simple fact that it’s aging. There’s a standard formula for depreciating the value of a commercial property, and that formula lowers the property value every year for a 39 year period.

Most investors choose what’s called “straight-line depreciation,” which means the property is depreciated a set amount every year during that time period. But it doesn’t have to work that way. Through cost segregation commercial real estate investors can take advantage of bonus depreciation or accelerated depreciation, which can mean a greatly reduced tax bill and big savings that can be used elsewhere or to purchase other properties.

The Value of a Cost Segregation Study

When a cost segregation study is completed on a property that a commercial real estate investor has built, purchased, or otherwise acquired, the property can be converted from one type to another. Commercial properties are typically listed as 1250 properties, and with cost segregation, some of their components can be converted into 1245 property — which is tangible personal property. That accelerates depreciation on some components, both inside and outside the structure, over as little as five, seven, or 15 years time.

Doing that instead of using the typical 39 year depreciation schedule means that a lot larger amount of depreciation can be taken. Writing off assets at that accelerated rate results in a lower income tax rate for the investor. That adds to the profitability and cash flow of the business, and gives the investor an opportunity to reduce their tax burden on the properties they own. What they do with the additional cash they’re saving is up to them, but they won’t be paying it out in taxes due to traditional depreciation rules.

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How Does a Cost Segregation Study Work?

A cost segregation study can’t be carried out by just anyone. It has to be handled the right way, or it’s not considered to be valid for its intended purpose of saving the investor money. Additionally, some properties are a better fit for this type of tax break than others, and not everyone will see huge benefits. But that doesn’t mean it’s not worth checking into. Especially for investors who are dealing with multifamily financing on properties or who have large commercial buildings, the savings can be significant.

Professionals who handle these kinds of studies generally have experience in engineering, architecture, tax accounting, and construction. That way the person hired can provide the right kind of cost segregation analysis for the commercial property. Some of the systems that can be changed over to 1245 property and depreciated faster include carpeting and wall coverings, along with millwork, partitions, specialized equipment for the kitchen, and the electrical system.

The ventilation system and concrete slab floor also qualify, as do lighting fixtures, specialized plumbing, process piping, storage tanks, and the phone and computer systems. That’s a lot of areas of the structure that can be depreciated faster through this process. With cost segregation commercial real estate investors have the opportunity to reduce their tax burden quickly and efficiently in a way that’s safe and legal. By working with a professional, the process can also be less stressful.

Cost Segregation Studies Aren’t Without a Price Tag

The price of one of these studies can range from $10,000 to $15,000. That’s a lot to spend, which is why the studies are more commonly used for larger pieces of commercial real estate. A cost segregation study is often not worth the price for residential or very small commercial properties. But for those investors who would noticeably benefit from a reduced rate of federal income tax, a cost segregation study can be a wise choice.

When the savings from a study like this would make a big difference or a property is generating a lot of income, it can make sense to pursue getting a cost segregation study commercial real estate investors can rely on and use for their tax protection. With multifamily financing properties and other issues to consider, it’s worth looking at the price and the benefits to determine if a cost segregation study is right for you.

It’s also important to consider when a study should be conducted, but it’s generally recommended that the study is done right after the purchase or development of the property. If that’s not feasible, getting it done within the first year is common and will provide valuable tax benefits for a lot of commercial investors. There are pros and cons to this kind of study, just like with anything that affects the value of other financial considerations of an investment.

The Tax Cut and Jobs Act

One additional piece of information about cost segregation that’s worth noting is the Tax Cut and Jobs Act. This legislation added the Section 179 deduction to the IRS code, and that allows business owners to take bonus depreciation. It’s a big bonus, too, with 100% bonus depreciation for qualified assets in their first year. Those qualified assets are defined through a cost segregation study, so the bonus isn’t going to be available without a study on the property.

The bonus depreciation works in place of depreciating the assets over time, but the bonus is also only available until 2022. After that, it will start to be phased out and will be gone completely by 2027. The best thing to do is to take advantage of it now if it’s something you will benefit from as a real estate investor. Not all investors will see benefits from a cost segregation study that outweigh the cost of the study, but for those who do the perks can be highly valuable and very much worth the time and price tag.

There’s no reason to overpay on income taxes when there are legal ways to reduce your tax burden as a commercial real estate investor. A cost segregation analysis and an adjustment to commercial real estate depreciation on the properties you own could be the way to reduce how much tax you’re paying and see more benefit from your properties. People who invest in commercial real estate are generally looking for a good return on their investment, so why not take all the breaks that are available?

About Author

David Luke

David Luke

David was immediately drawn to the CommLoan mission of creating a better borrower experience when joining the firm in 2015. Initially, David helped grow the lenders on the platform by 6X and worked closely with the software team to improve accuracy and efficiency within the loan fulfillment process. David has underwritten and closed more than $2 billion in transactions ranging from bridge to permanent financing across all major capital sources. He appreciates the wealth creation that real estate has to offer and has been self-managing a small portfolio of single and multifamily properties for the last 10 years. David earned a master’s degree in business from W.P. Carey School of Business at ASU and will be completing his CCIM Designation in 2021. Show More...