A cost segregation study is an advanced tax strategy for companies or individuals who have purchased, constructed, or renovated real estate. The study, usually conducted by engineers, tax specialists, and financial advisors, involves an in-depth analysis, to identify and break down specific assets which may be isolated from the real estate for depreciation purposes. The costs of these separated assets are then allocated to appropriate depreciation periods.
Office buildings, hotels, warehouses, casinos, dealerships, and entertainment venues are a few examples of properties which may be eligible for a cost segregation study. On the other hand, primary residences are strictly not eligible for cost segregation studies. Cost Segregation studies are encouraged immediately after the purchase of a new property but may be conducted at any time after purchase.
Why Should I Conduct A Cost Segregation Study?
Cost segregation studies function to accelerate cash flows for investors in real estate. Segregating assets allows investors to assign shorter depreciation periods to specific assets. The assignment of shorter depreciation timelines will decrease taxable income in that tax period, allowing for advances in cash flows which would have been realized in a later period under a typical 27.5- or 39-year depreciation. The advances in cashflows gives investors added liquidity and flexibility for future projects.
How Does A Cost Segregation Study Work?
The cost segregation study separates the total dollar amount invested into: the value of the building and the value of individual components in the building. An illustrative example is that of an investor buying a laundromat. In this scenario, Investor X paid $1,000,000 for the laundromat. Under normal conditions the land would not depreciate, while the building would be depreciated on a standard 39-year timeline. Under this schedule the building would generate a yearly depreciation expense of about $25,641.
However, if Investor X conducted a segregation study, he may discover that his laundry machines are worth $200,000, the value of his piping and wiring is $100,000, and other personal properties in the building are valued at $150,000. Depreciating these items over 5 years instead of 39 years would significantly increase Investor X’s cash flow. His annual depreciation total would increase from about $25,641 to about $109,102 for the five years, greatly reducing his tax liabilities. An even greater advantage would be if these items are available for bonus depreciation, allowing them to be depreciated within one year. Additionally, if Investor X took out a loan of $800,000 for his initial investment, he would have only paid $200,000 out of pocket and could potentially receive about $109,102 in tax deductions within the first year.
In Conclusion, a cost segregation study is an extremely powerful tax strategy for real estate investors looking to advance cash flow and increase flexibility. By separating specific assets and assigning shorter depreciation periods, investors can significantly reduce their taxable income in the early years of their investment. The advancement in cash flow would allow the investor to focus on future projects without having cash tied up in slowly depreciating assets. While the study requires some initial expenses and time to conduct, the potential savings far exceed these costs.
