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Investing in real estate is a strategic move that can yield significant financial benefits in various ways. By making smart choices, you can enhance your cash flow through real estate investments.
Depreciation, an accounting technique, allows businesses to allocate the cost of tangible property's wear and tear over its useful life, adhering to IRS guidelines.
This method enables businesses to secure essential tax breaks. For instance, commercial and residential properties can be depreciated over 39 years and 27.5 years respectively, using the straight-line method as prescribed by the U.S. Tax Code.
Let’s explore how cost segregation can assist you and how it is connected to bonus depreciation and accelerated depreciation.
Cost Segregation in Real Estate Investment
Cost segregation is not applicable to your primary residence; it's exclusively beneficial for properties acquired as investments. This method offers a faster way to depreciate the cost of your investment properties. The depreciation of any investment real estate is deductible over time on your income taxes, and the duration varies based on the property type.
Using cost segregation, the depreciation schedule is accelerated, allowing for larger annual deductions. This strategy effectively reduces your yearly income tax liability and lowers the costs associated with owning investment properties.
Key elements often involve personal property or land improvements, which can be depreciated over shorter durations of 5, 7, or 15 years, as opposed to the longer spans typically allotted to the building itself, usually 27.5 or 39 years.
Best Time to Conduct a Cost Segregation Study
A cost segregation study can be initiated at any point after you purchase, construct, or renovate a property. However, the ideal time to undertake this study is within the same year that these real estate activities occur. Doing so maximizes tax savings, especially when your expenditure on the property is likely at its peak.
If the optimal timing is missed, you can still benefit from catch-up tax deductions through a look-back study, which the IRS permits for any relevant property actions dating back to January 1, 1987.
Advantages of Cost Segregation
Cost segregation serves as a significant financial strategy by:
- Accelerating depreciation claims on investment properties: This method allows for the depreciation of specific components like electrical and plumbing systems over shorter periods (5, 7, or 15 years) rather than the standard 27.5 or 39 years for the entire building.
- Lowering annual tax liabilities on properties: By increasing depreciation deductions early, you reduce the income taxes due on your investment properties each year.
- Enhancing cash flow: The immediate tax savings provide additional liquidity, potentially enabling further investment in real estate to expand your portfolio.
Limitations of Cost Segregation
While cost segregation is a valuable tax strategy for real estate investors, it also has some limitations:
- Cost implications: The fee for a cost segregation study varies based on property size, type, and the level of detail required in documentation. Prices generally range from $5,000 to $15,000.
- Time-consuming process: The duration of a cost segregation study can extend up to two months, depending on the complexities and specifics of the property involved.
Bonus Depreciation
Bonus depreciation, enhanced by the Tax Cuts and Jobs Act of 2017, allows building owners substantial one-time deductions. From 2023, this benefit will decrease by 20% annually. For example, in 2022, a building owner could deduct 100% of the cost of qualified property, but this dropped to 80% in 2023, 60% in 2024, and so forth.
Linking Cost Segregation with Bonus Depreciation
Following the Tax Cuts and Jobs Act (TCJA), cost segregation's value significantly increased due to the provision for 100% bonus depreciation. This provision applies to qualified property with a life expectancy of 20 years or less, allowing owners to write off the entire cost in the first year of service.
This ability to deduct the entire cost immediately can be highly advantageous, potentially creating a tax loss that offsets taxes owed and carrying forward any unused tax losses.
How to maximize Bonus Depreciation
To fully leverage bonus depreciation benefits, precise planning and timing are essential. The bonus depreciation rate depends on the year a property is placed in service. Completing projects and placing assets in service within the specified tax year is crucial to securing the desired depreciation rate.
This approach is especially important for property acquisitions and renovations, where the date the asset is placed in service significantly influences the available depreciation benefits. Even if the projected income for the year doesn't initially justify the deduction, placing assets in service secures the higher bonus rate. In cases where income is insufficient in the acquisition year, a look-back study can be used in subsequent years to claim depreciation retroactively.
Additionally, it’s vital to stay updated on state-specific tax rules, as many states do not conform to federal bonus depreciation guidelines, affecting overall tax strategies as federal benefits phase out.
Accelerated Depreciation
This method allows for a faster depreciation of assets over a shorter life span than the traditional straight-line depreciation. Using the Modified Accelerated Cost Recovery System (MACRS), assets are depreciated over their useful lives but at a faster rate in the early years. Accelerated depreciation enhances cash flow by reducing tax liability sooner than it would under normal depreciation schedules. For certain assets, such as personal property or certain land improvements, depreciation periods can be significantly shortened, boosting the depreciation deductions available in the early years of asset life.
Difference between Cost Segregation and Accelerated Depreciation
Accelerated Depreciation is a broader term that refers to any method of depreciation used by businesses for accounting or income tax purposes that allows for higher depreciation expenses in the early years of an asset's life. Accelerated depreciation can apply to any asset, not just those identified through a cost segregation study.
In practice, cost segregation is a technique to achieve accelerated depreciation. In order to appropriately accelerate the depreciation of your assets, property owners will need a cost segregation study. By conducting a cost segregation study, you can identify parts of a property that can be depreciated faster than the building's standard depreciation schedule. This allows for greater tax benefits in the earlier years of the asset's life, which is essentially the goal of accelerated depreciation.
If you're wish to learn more or looking to leverage cost segregation and accelerated depreciation to generate cash flow for your next investment, let's connect!
