By Geoffrey Gan
“Real estate is a great tax strategy.” We hear this phrase, or some version of it, all the time. Aside from being able to deduct your primary residence’s mortgage interest, how does owning real estate benefit you, as a taxpayer? For investment real estate, this strategy is Cost Segregation.
While even the most inexperienced investor in real estate and their accountant know that the depreciation of the building over time is tax deductible this process can take decades until it shows a real bottom-line impact.
What Cost Segregation does is place a tax value (basis) on the different components of a property and assign the proper tax recovery lives to the assets, instead of depreciating it as a slowly depreciating building. By identifying and assigning shorter tax lives to various assets, you can accelerate the depreciation on an asset, giving you a larger deduction to your income in that tax year.
Let’s say that after a Cost Segregation study, the carpet in your office building had a basis of $5,000. If you never conducted the Cost Segregation study, this $5,000 asset would depreciate over thirty-nine years, essentially giving you a deduction of $128 a year. But by assigning its proper tax life of five years, that carpet asset would result in a $1,000 deduction over the next five years. And with another special tax provision called bonus depreciation, you would likely be able to deduct even more than that $1,000 (bonus depreciation for 2023 is 80%, so you would be able to deduct $4,000 this year!). And this is just for the carpet!
If you are already purchasing an asset for investment, a Cost Segregation study should be considered as it simply unlocks cash flow; you are essentially taking your future years’ tax deductions and applying them in the current year.
Cost Segregation is a time-value of money play – that a dollar in your pocket saved on paying taxes today is worth more than that same dollar tomorrow (or next year). With inflation being a hot topic in today’s economy, the current value of a dollar holds more purchasing power (or opportunity) than it would in the future.
This strategy is of course only used with investment property, not your primary residence.
Investment real estate is any property whose primary purpose is to generate income. This can be a short-term, single-family residential house in Palm Springs put up on Airbnb; it could be the office building your company purchased and is leasing to itself; the office building you own and lease to another company; or investment property could be the restaurant build-out for a popular franchising chain. The income received from these types of real estate investments via rent or business revenue will be taxed; Uncle Sam will always demand his share.
Having to pay taxes on your income is nothing new; however, investing in a tangible real estate asset, you inevitably unlock the provision of depreciation. Depreciation is the government’s practice of allowing a taxpayer to recover the allocable* cost of an income-generating asset since that physical asset is used and degrades over time (*the land portion in a typical purchase of a property is not depreciated). The carpet gets worn out, air-conditioning systems need replacing, and all roofs will eventually leak. The recovery of the cost of these assets will be in the form of a deduction, similar to your house’s mortgage interest.
Accounting 101 aside: a deduction is the reduction of taxable income. If you made $100,000 and were taxed at 35%, you would have to pay $35,000 in taxes that year. If you had a deduction of $40,000, your taxable income would then be $60,000. Your 35% tax payment on the $60,000 income would be $21,000. Most taxpayers would rather pay $21,000 in taxes than $35,000, right? Understanding the benefit of a deduction forms the backbone of Cost Segregation.
So while recovering the cost of your investment property sounds great, the time in which you recover the cost of that asset is lengthy. This is largely because when you purchase a property (or build one), all of the components that make up the building (carpet, HVAC, roof, etc.) are not separated out and instead will be depreciated as a single (“Building”) asset. Your accountant does not break down the property into various components. Instead, what usually happens, is you tell your accountant that you purchased a property, then they will likely split the building value from the land value of the purchase price and put it “on the books” where the building asset will depreciate and the land value will not (again, the land portion does not give you the benefit of depreciation deductions, as land “retains” value regardless of usage). The single Building asset will then depreciate over the maximum length of time for real estate property. For commercial properties, this is thirty-nine years; for residential properties, this is twenty-seven and a half years.
For example, let’s say you purchased an office building for $500,000. After we take out the land value of $110,000, you get to depreciate (or recover the cost of) the $390,000 over thirty-nine years. Essentially you would be getting a $10,000 deduction to your income every year for thirty-nine years.
Your depreciation schedule would look something like this (the following example is heavily simplified):
|Asset Number||Description||Cost/Basis||Tax Life||Current Year Depreciation|
A $10,000 reduction in income is better than nothing, but when you dig into the purchase of the building, you are buying a collection of different components (e.g. carpet, HVAC, roofing, parking lot, etc.) that make up the property. All these various tangible assets have different tax recovery lives, respectively, and a significant amount of these assets have shorter recovery lives than the thirty-nine-year office building asset.
It is not out of the realm of possibility that a Cost Segregation study will allow you to deduct 10%-30% of the building’s basis in year one. In our office example, this could be a $70,000 deduction. Or higher. It is important to note that different types of properties yield different results and that all properties are different. A Cost Segregation study is similar to a property appraisal in the sense that a physical inspection is needed – to identify, measure, and understand the condition of the various assets.
Using Cost Segregation as a tax strategy will result generally in dramatically lowering your taxable income. And who wants to more taxes than they need to?
Geoffrey Gan brings more than 20 years of overall professional experience related to cost segregation, management consulting, construction, real estate, and software application development.
Since 2004, he has overseen and performed thousands of cost segregation studies for real estate assets including: apartment complexes, auto dealerships, high-rise office buildings, industrial manufacturing facilities, hotels and casinos, medical offices, retail centers, single family rentals, and veterinary clinics.
Geoff Gan has a Master’s in Business Administration and a Bachelor’s in Computer Science both from the University of Southern California. Gan is a Certified Cost Segregation Professional as part of the American Society of Cost Segregation Professionals. He can be reached at (626) 410-0645 or visit gtgconsultingllc.com for more information.