“It's not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for” - Robert Kiyosaki

Cost Segregation Studies: The Secret to Tax Benefits

One of the secrets real estate investors use to seriously lower their taxable income is something called a cost segregation study. A qualified cost segregation study presents an opportunity for real estate investors to accelerate depreciation and reduce federally taxable income. In this article, we delve into the key aspects of cost segregation studies and why they are a game-changer for multifamily investors.

How Does A Cost Segregation Study Work?

Cost segregation is a powerful tool that allows those who purchased or remodeled investment property to increase cash flow by accelerating depreciation schedules and deferring income taxes.

A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations.

The primary goal of a cost segregation study is to identify all building costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for commercial properties and 27.5 years for rental residential properties).

Example:

• 5 year tax-life components: cabinets, appliances, carpeting, flooring, light fixtures, ceiling fans, etc.

•  7 year tax-life components: office furniture, telecommunication systems, cables, telephones, etc.

• 15 year tax-life components: parking lots, driveways, sidewalk, curbs, landscaping, etc.

Reducing tax lives results in:

• Increased cash flow

• Accelerated depreciation deductions

• Reduced tax liability

The depreciation deductions only count the value of the building, not the land.

Instead of waiting to take depreciation over the 5, 7, or 15-year depreciation term of an asset,  property owners can take the entire unrecognized depreciation deduction in the year of the cost segregation study. This allows property owners to seriously reduce their income taxes.

Who Performs Cost Segregation Studies?

Typically it is a team of tax advisors and engineers working together to decide:

• which building components should go into each category

• how much each element costs on its own

Here’s a Cost Segregation Study example:

You and your partners buy a commercial building for $10,000,000.

Remember that the land isn’t depreciable, so in this example:

• the land is worth $2,000,000

• the building is worth $8,000,000

If you depreciate the building over 39 years, the depreciation write-off would be $205,128.21 per year. Assuming a 37% federal income tax rate, that would save you $75,897.44 in taxes.

Now, let’s say you decide to get a cost segregation study. After completing the study, your advisory team identifies the following costs:

• $1,000,000 of interior fixtures and finishes that can be depreciated over five years

• $1,000,000 of interior fixtures that can be depreciated over seven years

• $1,000,000 of land improvements that can be depreciated over 15 years

Based on the study, $3,000,000 of the $8,000,000 building is eligible for bonus depreciation.

Even if you didn’t take advantage of bonus depreciation, those items could be depreciated over a shorter recovery period using an accelerated depreciation method.

As a result, your estimated first-year depreciation write-off would be:

• Building ($5,000,000 / 39 years): $128,205.13

• 5-year property ($1,000,000 / 5 years): $200,000

• 7-year property ($1,000,000 / 7 years): $142,857.14

• 15-year property ($1,000,000 / 15 years): $66,666.67

• Total first-year depreciation expense: $537,728.94

So even if you didn’t take advantage of bonus depreciation, the first-year depreciation write-off would result in a tax savings of $123,062.27 over depreciating the building over 39 years with no cost segregation. (($537,728.94 – $205,128.21) x 37%).

Benefits Of A Cost Segregation Study

A cost segregation study can reduce tax liability and increase cash flow in the early years of owning a rental property.

It gives you the ability to defer taxes and the opportunity to reclaim past depreciation deductions.

Thanks to the Tax Cuts and Jobs Act passed in 2017, used personal property placed into service after September 27, 2017 is eligible for bonus depreciation. That means real estate investors could deduct 5, 7, and 15 year property all in the first year, which this tax strategy makes cost segregation powerful. The Tax Cuts and Jobs Act of 2017 bonus depreciation schedule is currently set to sunset in 2027. The allowable deduction is at 80% in 2023 and will go down by 20% each year until the projected phase out of 2027.*

What Does a Cost Segregation Study Cost?

Typically, both the cost of a cost segregation study will vary depending on:

• size of the property

• building type

• other physical characteristics

There’s a wide range of fees that vary from $5,000 to $25,000+ to complete a study depending on the project.

Bottom Line:

If you’re a busy, high-income earner and don’t have time to deal with tenants, then investing passively in real estate syndications might be right for you. This allows you to create extra income streams and receive tax benefits to reach financial freedom much quicker than what you may have thought possible.

At MFI Partners, our value-add Multifamily Syndication offerings involve the use of cost segregation, which makes the passive income in some cases, virtually tax-free.

If you would like to learn more about how syndications work,

Schedule a Call here