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Cost Segregation Services: How does it Work?

Posted On Friday, 05 August 2022 21:13
Cost Segregation Services: How does it Work?

Have you ever wondered why some wealthy people appear to pay fewer taxes? That is because anyone, including you, can benefit from the tax system, especially if you know the basic rules. You no longer have to do extensive research to know that real estate investors only pay fewer taxes on their rental real estate revenue. Now, this is when cost segregation services enter the scene.

Whenever you construct or buy a commercial property, it creates a building asset. And then, money is entered into a fixed-asset system, and owners can take shares of the purchase as taxable income deductions annually. Cost segregation studies analyze the components of the building and then assign them with recovery periods, providing property owners with tax advantages.

Understanding cost segregation

One of the reasons why commercial real estate is lucrative is being able to take advantage of depreciation. Buildings wear out eventually, so the IRS lets the owners deduct a particular amount from their income annually before applying taxes. And since this is an imaginary expense, the more you claim in depreciation, the fewer taxes you’re obliged to pay.

Cost segregation is a strategy you can use to maximize the depreciation expense amount you can claim. It identifies assets within a building where you can accelerate the abstract decline over a shorter period instead of the standard 39-year method. Isn’t this cheating the system? How does this work? The process is a combination of tax expertise, engineering, and construction, maximizing tax deductions for real estate investments.

Cost segregation services: How to calculate depreciation on a commercial property

You can track depreciation in many ways, but the easiest way is to check how long it takes the asset to fall apart completely. Then, divide how much you paid by the number of years, also known as “straight-line depreciation.”

Straight-line depreciation is when you claim the same amount in depreciation expense per year. In these calculations, the IRS has created a set of rules, such that single and multi-family rentals are to last 27.5 years and 39 years for commercial properties.

However, you must avoid taking the sale price too quickly and dividing it by 39 years. Because when you buy a property, you aren’t only buying the building; You are also purchasing the land it sits on. While the building depreciates, the land doesn’t, as the IRS has also mentioned. You need to split the purchase price into two - the one you paid for the building and the other for the land. Then, you can divide it by 39 years to calculate your annual depreciation expense.

The cost segregation process

You may not understand it now, but cost segregation is not as complicated as you think. The IRS has set timelines for how different properties will last, so it can be beneficial to take a portion of the sale price you’ve paid for the property and then split it up even further. You can redefine the category of something and claim that it has a shorter lifetime, speeding up the amount of expense during the early years of ownership, also known as “accelerated depreciation.” 

The expense is paper loss, which means the higher you can make it, the bigger the revenue you can keep from taxes. However, it will still depend on which of your property will fall into each of the categories:

  • The land – not expensed
  • The building – expensed over 39 years (commercial) or 27.5 years (residential)
  • Improvements – expensed over 15 years
  • Personal property – expensed over 5 or 7 years

 

The definitions of where your property fits can be unclear, so you need to hire an experienced professional to initiate a cost segregation study. Instead of doing all the work, you can avail cost segregation services to figure it out. You’ll be working with a team that consists of engineers, lawyers, and accountants who will help decide which things fall under which category.

Why are cost segregation services necessary?

Segregating the costs of a property means a lot to property owners because of the financial benefits they get. While there may be fees associated with availing of cost segregation services, the tax savings from accelerating depreciation deductions can lead to an increased cash flow.

You can measure the benefits of cost segregation in terms of the following:

  • Increased cash flow during the early years, as well as the greatest benefit from a cost segregation study.
  • NPV or net present value of obtaining depreciation expense deductions earlier.

However, if you do not plan to hold the property for the long term, you may not get any benefit at all. That is because any up-front benefits reverse once you sell the property.

Who should conduct cost segregation studies? Do you really need to hire a team for cost segregation services? Performing such an analysis isn’t feasible if you are doing it alone. It involves a team of tax advisors, engineers, and lawyers to decide which component goes into which category. They also determine how much each element will cost on its own.

How do cost segregation studies work?

Cost segregation studies aim to identify all property-related costs that depreciate over time – in five, seven, and 15 years, or whichever gets written off faster. In order to accomplish this, your team will review all available property records, cost details, inspections, and blueprints. They may even perform a physical inspection of the property to obtain a more accurate report.

How do you know when to get cost segregation services? It’s best to do this during the year you are buying, constructing, or remodeling a commercial property. However, if you forgot to do it, you can opt for a look-back study to adjust your depreciation schedule. Doing this will help you make a catch-up in missed depreciation adjustments.

Availing of cost segregation services allows you to speed up depreciation in the early years of building ownership. This frees up capital once you are ready to invest in your business. For organizations that own commercial estate, cost segregation is an invaluable opportunity to reduce tax liability while also increasing short-term cash flow.

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