Tax Savings Strategy for Income Producing Property Owners: Cost Segregation
As we near April 15, Tax Day, a lot of investors start thinking about what they can do differently this year so they will not have to pay as much in taxes next year. The goal is to minimize taxes while still maximizing income, and real estate investments offer a variety of ways to do this. I’ve talked about tax deferred exchanges, tax appeals and using depreciation as tax savings strategies in the past, but today I want to highlight Cost Segregation and expensing existing building components, if they have been substantially repaired or replaced during the tax year.
Historically, when an investor bought a building they would assign a value to the land, which cannot be depreciated, and a value to the building, which can be depreciated over the life of the asset. For residential property this is 27.5 years and for commercial buildings it is 39 years. For a $1,000,000 purchase of a commercial building, this might look like $220,000 as land and $780,000 as the building. Depreciating the building over 39 years would mean an investor could write off $20,000 per year of the buildings value and decrease taxable income by this amount each year.
Costs segregation is a method of assigning values to different components of a building when it is purchased, some of which can be depreciated faster than 39 years. For example phone systems, some electrical systems, and carpet can be depreciated over 5 years. If it is determined in the above example that 10% of the building are these components, $78,000 of the building could be depreciated over 5 years, meaning the total depreciation on the separate components the first 5 years would increase to $33,600. For taxpayers in the 28% tax bracket, this would mean a savings of $3,808 on their taxes. Cost Segregation can be used for many other components of the property including the asphalt in the parking lot, sidewalks, landscaping, decorative improvements, mill work, movable partitions, and many other items.
Building owners that did not cost segregate at the purchase of their building may still be able to write off some parts of the building thanks to IRS regulations that were adopted two years ago (called the Tangible Property Regulations or Repair Regulations). Prior to the new regulations if the building owner replaced a component of the building, for example the roof, they would still be depreciating the old roof as part of the main building. Under the new regulations the remaining cost (the part of the old roof that hasn’t been depreciated yet) can be written off in the year the new roof is placed in service. In order to do this, the current value of the old roof must be calculated and this value would be the amount that can be written off.
The process can be very involved and an experienced accountant or company that specializes in cost segregation will be essential to the process. As a general rule of thumb the initial cost segregation study will be worthwhile for purchases over $1,000,000 while potentially not offering as much savings for less expensive buildings due to the cost of the study.
Dan Stiebel, CCIM