How to Use Cost Segregation to Defer Taxes on Real Estate

Cost segregation in real estate is a strategic tax planning tool that can allow investors to accelerate depreciation deductions and thereby defer taxes. This strategy is typically used for properties that produce taxable income and not those that operate a loss. By identifying and reclassifying personal property assets like fixtures and fittings from real property, which has a longer depreciation period, investors can take advantage of shorter depreciation schedules. This can result in larger deductions in the early years of property ownership and in turn, leads to deferred tax liability. Investors can then reinvest the tax savings into other projects, growing their portfolios more rapidly.

A financial advisor can help you analyze real estate investments for your portfolio and create a plan to manage them.

What Is Cost Segregation?

Cost segregation is a tax planning strategy that allows real estate investors to accelerate depreciation deductions by reclassifying certain components of a property.

Typically, real estate properties are depreciated over a long period, usually 27.5 years for residential rental property and 39 years for commercial property . However, through cost segregation, parts of the property - such as personal property assets, land improvements and certain building components - can be identified and reclassified into shorter-lived asset classes, such as five, seven or 15-year periods. This process requires a detailed engineering study conducted by professionals who examine the property and its assets.

The result of this reclassification is a larger depreciation deduction in the early years of ownership, leading to significant tax savings and improved cash flow. By accelerating depreciation, cost segregation effectively defers federal and state income taxes, allowing real estate investors to reinvest the tax savings into their business or other investments.

It’s important to note that while cost segregation can offer substantial financial benefits, it must be performed in compliance with IRS guidelines. Consulting with a tax advisor or cost segregation specialist is crucial to ensure accurate and compliant implementation.

How Does a Cost Segregation Study Work?

To determine whether your investment property is a good candidate for cost segregation, it’s necessary to complete a cost segregation study.

A cost segregation study begins with a thorough analysis of a property by a team of specialists, typically including engineers, architects and tax professionals. These experts meticulously examine all aspects of the property, identifying and categorizing each asset according to its useful life. This inspection often involves reviewing architectural drawings, conducting site visits and assessing construction costs.

The goal of this process is to reclassify certain assets, such as interior fixtures and plumbing, from the standard 27.5- or 39-year depreciation schedule into shorter-lived categories, often five, seven, or 15 years.

Once the assets have been identified and reclassified, the specialists will compile a comprehensive report that outlines their findings and provides the necessary documentation to support the accelerated depreciation claims. This report is then used to adjust the property owner’s tax filings, allowing them to claim the increased depreciation deductions.

If successful, the result is a significant reduction in taxable income in the early years of property ownership, leading to immediate tax savings and improved cash flow .

How Cost Segregation Can Improve Your Tax Liability

For real estate investors , cost segregation offers a powerful tool to manage and improve tax liability. By accelerating the depreciation of specific components of a property, investors can significantly reduce their taxable income in the initial years of property ownership.

Typically, real estate assets are depreciated over a long period, which spreads out the tax benefits. However, through cost segregation, items such as carpeting and electrical systems can be classified into shorter depreciation periods of five, seven, or 15 years. This front-loading of depreciation deductions translates into immediate tax savings and enhanced cash flow, which property owners can then reinvest into additional properties or other ventures.

The benefits of cost segregation extend beyond mere tax deferral.

Additionally, improved cash flow from reduced tax payments can bolster an investor's financial flexibility, enabling more strategic reinvestment and growth opportunities. This increased liquidity also can aid in covering property maintenance, renovations or other operational expenses without incurring additional debt.

Further, by conducting a cost segregation study, investors ensure they are fully leveraging the tax code to their advantage, which can lead to optimized financial performance. It's crucial, however, to engage with experienced professionals to conduct these studies to ensure compliance with IRS regulations and to accurately maximize the available benefits.

Other Tax Tips for Real Estate Investors

Real estate investors have several strategies at their disposal to optimize tax savings beyond cost segregation. Here are seven common tips:

• Use 1031 exchanges. A 1031 exchange allows investors to defer capital gains taxes by swapping a property that you want to sell with a similar, like-kind property. This strategy not only defers taxes but also helps in building and diversifying a real estate portfolio without the immediate tax burden.
• Claim depreciation deductions. Depreciation is a non-cash deduction that investors can claim on their rental properties, reducing taxable income. While cost segregation accelerates this benefit, standard depreciation over 27.5 years for residential properties and 39 years for commercial properties remains a valuable tax-saving tool.
• Take advantage of tax deductions. Real estate investors can deduct expenses associated with managing their properties, including mortgage interest, property taxes , insurance premiums, maintenance costs and property management fees. These deductions can significantly lower taxable income.
• Benefit from passive activity losses. Investors can use passive activity losses (PALs) to offset other passive income . If real estate activities result in a net loss, these losses can reduce taxable income from other passive activities, subject to certain IRS limitations and qualifications.
• Leverage Opportunity Zones. Investing in opportunity zones provides tax incentives for long-term investments in economically distressed areas. Investors can defer capital gains taxes and potentially reduce them based on the length of time the investment is held, fostering both tax savings and community development.
• Consider real estate professional status. Achieving real estate professional status can offer substantial tax benefits. By meeting specific IRS criteria, which requires that more than half of your income-producing time provides real estate-related services, investors can offset active income with rental property losses.
• Use home office deductions. Real estate investors who use part of their home exclusively for business purposes can claim a home office deduction. This can include a portion of rent or mortgage, utilities and home maintenance, reducing overall taxable income. Engaging a knowledgeable tax advisor to navigate these strategies ensures compliance with IRS regulations while maximizing tax benefits.

Bottom Line

Incorporating cost segregation into your real estate investment strategy has the potential to significantly enhance your financial outcomes by deferring taxes and improving cash flow. By accelerating depreciation on specific property components, investors can realize substantial tax savings in the early years of ownership. This increased liquidity can then be reinvested into additional properties or other ventures, driving portfolio growth and overall financial health.

Investment Planning Tips

• A well-executed cost segregation study can not only optimize tax benefits but also align with your long-term investment goals. If you want to invest in real estate, a financial advisor can help you understand cost segregation and maximize its advantages. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you want to invest in real estate to diversify your portfolio, you should know what asset allocation is right for your level of risk tolerance. SmartAsset's asset allocation calculator can help you find out.

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