Cost Segregation: How to Maximize the Tax Benefits of Investing in CRE

I recently wrote a post on Depreciation and the tax shelter benefits it gives to the Commercial Real Estate investor. Depreciation is a powerful benefit of investing in CRE and reduces the investor’s taxable income resulting in less income tax paid. It is a beautiful thing. But, there is a way to maximize its benefits, and that way is cost segregation.

Now hang with me for a minute and image you have owned a piece of investment real estate for a number of years. You understand that if it is commercial property, then you can depreciate it over 39 years. But what if you make a capital expenditure (anything that’s useful life is generally longer than a year)

– If you were to replace the carpeting in your property, it doesn’t make sense that you would depreciate that over 39 years. The IRS allows you to depreciate the carpet on a 5-year schedule.

– If you paint or wallpaper, you can also use a 5-year schedule.

– If you spend thousands of dollars redoing all the landscaping, you can depreciate that expense over 15 years.

– If you put in new furniture or a HVAC window unit, you can use a 7-year schedule.

Now think about what you are buying when you buy a new property. You are buying the flooring in that building. You are buying the landscaping on that property. All the components in that building that should be on shorter depreciation schedules are all wrapped up in the purchase price of that property. Does it seem right that all of those components have to be depreciated over 39 years (or 27.5 years if the property is residential)?

No – it doesn’t.

Enter a cost segregation study. A cost segregation study looks at a building, segregates all its parts, and then puts them on the appropriate depreciation schedules. This allows a property owner (hopefully you) to depreciate a portion of the property much faster. This allows you to reduce your taxable income more quickly in the earlier years of owner a property.

I recently bought a strip center with a group of investors for $3,500,000. I allocated $700,000 of value to the land (you can never depreciate land) leaving $2,800,000 of value to the building. If I didn’t do a cost segregation study, the depreciation on the property would have about $72,000 a year for 39 years. Not bad.

But I did do the cost segregation study. The study put 12.33% of the value of the property on a 5-year schedule. This included things like retail display lighting, kitchen equipment, laminate flooring, decorative trim, carpeting, etc. The study also put 13.73% of the value of the property on a 15-year schedule which included site improvements and the signage. There was nothing put on the 7-year schedule.

So now, I have about $2,000,000 of value on a 39-year schedule, $345,000 on a 5-year schedule, and $385,000 on a 15-year schedule. For the first five years, our investment group will be able to depreciate the following:

  1. 5-year schedule – $345,000/5 = $69,000/year for 5 years and then this schedule runs out
  2. 15-year schedule – $385,000/15 = $25,667/year for 15 year and then this schedule runs out
  3. 39-year schedule – $2,000,000/39 = $51,282/year for 39 years…and you get the picture

So instead of $72,000 a year of depreciation for our investment group, we get $69,000 plus $25,667 plus $51,282 for a total of $145,949 (at least of the first 5 years). When you are reducing your taxable income, more is better.

There are two things to note about cost segregation studies. The first is the IRS is ok with it. In fact, they provide the guidelines on how it is to be done. They even communicate in the tax code that this is the proper way to account for a property. Or, in other words, if you aren’t doing a cost segregation study, you’re wrong. There is no penalty if you don’t do one so don’t dismay. You are just leaving money on the table.

The second thing to note is the IRS requires the study be done by an accountant or engineer. You can’t do it yourself. So there is an expense to getting the study done. Most of the time, if the property value is $1,000,000 or more, this is a no-brainer.

If you would like to talk more about depreciation or cost segregation studies, we are here to help. Commercial Real Estate is one of the best wealth-building vehicles, and its tax-sheltering benefits are a big reason why. Take advantage!