You probably have been caught in the middle of a conversation about how unfair it is that wealthy individuals pay so little in taxes
I know, right? It’s like the tax system is designed to benefit the rich, and ends up being unfair to the middle class.
But that is a myth, and we’re here to clarify how the system works.
The truth is, all of us can benefit from the tax system, as long as we know how to play the game. There is no secret or hack that only the rich are using all you need to know is right out there in the open for anybody willing to figure out how to use it.
It’s time you learn about this little thing called Cost Segregation.
What is Cost Segregation?
Cost Segregation is a tax strategy that allows homeowners to apply accelerated depreciation deductions to increase cash flow and reduce the federal and state income taxes they pay on rental income.
This is done by breaking down and reclassifying certain internal and external components of a building, which are typically depreciated over 39 or 27.5 years for commercial and residential properties, respectively, into personal property or land improvements that are non-cash are depreciated over 5, 7, or 15 years.
To achieve this, a cost segregation study is necessary. These studies are often conducted by a team of qualified engineers and/or CPAs.
How Cost Segregation Benefits Investors
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As mentioned earlier, cost segregation can lower taxes and dramatically increase a property’s cash flow, especially in its first few years of operation.
Thanks to the Tax Cuts and Jobs Act, used movable goods put into service after 09/27/17 can benefit from a depreciation premium of 100%. This means that real estate investors can deduct 100% of 5, 7, and 15 year properties in the first year.
This is what makes cost segregation so powerful and can lead to significant tax savings!
Of course, the building itself will have to still be depreciated over 27.5 or 39 years. Also, remember that land can’t depreciate.
Let’s look at some examples:
Scenario A
Jane Doe, who is in the 24% tax bracket, buys a 24 unit apartment building for $1,000,000, places it into service in 2018, and does not utilize a cost segregation study.
Her CPA determines the following:
The building is then depreciated over 27.5 years, allowing her to take $29,090.91 as an annual depreciation expense.
Her income and expenses were as follows:
Jane will have to pay taxes on the $90,909.09 received from the property. However, the depreciation expense reduced her tax liability by $6,981.82, and since depreciation is a non-cash expense, Jane will still have the $29,090.91 in cash.
And it gets better.
Scenario B
Now, let’s say Jane decided to have a cost segregation study performed on her property.
The study finds that the value of the property is broken down as follows:
Thanks to the Tax Cuts and Jobs Act, Jane can take 100% bonus depreciation on the 5-year property, and land improvements in the first year.
The building is still depreciated over 27.5 years, allowing for an annual depreciation deduction of $13,090.
This gives her a total depreciation deduction in year one of $453,090.
Let’s take a look at how this affects her income this time around:
As you can see, Jane will show a net loss of $333,090 in year one. That means she will not have to pay any federal or state taxes on the $120,000 of net income. That’s $28,800 ($120,000 x 24%) in tax savings!
Plus, the remaining $333,090 loss will be carried forward and offset income in future years.
The additional cash flow can be distributed directly to Jane or her investors. Alternatively, it can be withheld for improvements and renovations that can increase the value of the property or be used as a down payment towards the purchase of additional properties.
Is a Cost Segregation Study Right for Me?
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Before dreaming about a Caribbean vacation, you should discuss with your tax advisor whether a cost segregation study is right for you.
There is a cost involved with having a study done, and the net benefit (or lack of it) depends largely on the property you own and other tax considerations.
Cost segregation has the potential to benefit any property. However, owners of larger apartment buildings or commercial properties will benefit most from these studies and should definitely consider one.
The Bottom Line
You don’t have to be in the 1% to apply cost segregation and to reduce your taxable income significantly.
All you need is a qualified tax advisor to help you decide whether this is the right option for your rental property and then guide you through the process.
If a cost segregation study will benefit you, gis found to benefit you, book this Caribbean vacation courtesy of Uncle Sam!