One of the reasons commercial real estate is a profitable business is due to its ability to make the most out of depreciation. Cost segregation, in layman’s term, is the method of maximizing the amount of depreciation expense one can claim by expediting the abstract decline in property value. Let’s take a look at how cost segregation services play out and whether they’re worth paying for.
But first things first: What exactly is Cost Segregation?
Cost segregation is a tax planning strategy that helps increase cash flow by expediting the depreciation of commercial building costs. A huge number of businesses often ignore the need for cost segregation services not knowing that it can save them thousands of dollars a year.
A cost segregation study is necessary in providing in-depth engineering analysis of the decline in value of long-term fixed assets, such as renovations, newly constructed buildings, and property acquisitions. Companies can accelerate tax deductions and improve their cash flow based off information from this study.
A quality cost segregation service allows owners to write of new or existing buildings in the shortest amount of time allowed under current tax laws. The positive rules on depreciation in the Tax Cuts & Jobs Act (TCJA) provides incentives for the use of cost segregation studies. It is important, therefore, that you work with a partner armed with the right experience in this field. You also want to make sure that your partner can deliver a quality study that satisfies all IRS guidelines.
How Do You Calculate Depreciation on a Commercial Property?
There are several ways owners can track depreciation but the easiest is to determine how long it will take the asset to completely fall apart (otherwise known as its “useful life”), and then divide the cost you paid for it by that many years.
This is a method called “straight line depreciation”, because you end up claiming the same amount each year in depreciation cost. The IRS has explained the rules concerning the length of time used for different items in these calculations, with single and multi-family rentals and commercial properties expected to last 27.5 years and 39 years respectively.
But don’t be too quick to simply take the sale price and divide it by 39 years.
When you purchase a property, you also end up purchasing both the building and the land it sits on. Although the building’s value can be depreciated, according to the IRS the land can’t be. This means you will have to divide that purchase price into two parts: the one you claim you paid for the land, and the one you claim you paid for the building. After you have a number for the building’s value, you can now divide that by 39 years to get the figure for your annual depreciation cost.
How Do Cost Segregation Work?
While the term “cost segregation” might seem intimidating and complicated, the good news is that it’s really not. Cost segregation services work the exact same way as we have previously explained. Because the IRS now has different timelines for how long certain things last, it is often a good idea to take part of the sale price you paid for the building and divide it even further.
In a ‘price divided by lifetime’ equation, as the total lifetime a property is spent on decreases, the annual depreciation cost increases. Thus, by redefining which category in the IRS it belongs to, you can claim it has a shorter lifetime and expedite the amount you spent in the early years of ownership. This is what we call an ‘accelerated depreciation’. Because this expense is a paper loss, the higher you can make it, the more money you can keep from being taxed.
In the end, how fast you can benefit from depreciation depends on how much of your property falls into the dour different categories under IRS. They are as follows:
- The land is not expensed
- The building is expensed (over 39 years for commercial properties, 27.5 years for residential properties)
- Improvements to the land (fencing and sidewalks) can be expensed for more than 15 years
- Personal Property that you personally chose, such as carpeting or bathroom fixture, can be expensed for over 5-7 years.
The limitations and definitions on the cost of things can be somewhat vague, making it an absolute necessity to hire experienced professionals to provide cost segregation services or cost segregation studies on your property. Instead of trying to figure out everything by yourself, a team of professionals (made up of accountants, lawyers and engineers) will work together to decide which things to place in each category.
Who Should Avail of a Cost Segregation Service?
Cost segregation studies usually happen when a property is being purchased or directly after it was purchased. Doing so will give buyer/s the correct information for their financial records from the beginning. After this, keeping things organized will simply be a breeze.
Is It Worth It?
A typical cost segregation study usually involves a site visit to the building. A cost segregation expert will walk the property, take pictures, and measure the items that can take the faster deductions. Once the site visit is completed, the cost breakdowns are then calculated. This process can result to an average of $20,000–$100,000 tax savings over a period of five years.
There are several factors that can determine whether the cost segregation service is beneficial for a particular business. Some of these factors include:
Cost—how much did it cost? The higher the initial cost, the better the chances of getting tax benefits.
Type of Business—what type of business is it? Some businesses, such as hotels and restaurants, have special rules to shorten depreciation even further.
Length of Ownership—how long will you own the property. If you plan on selling your property in the future, there might not be a lot of benefits.
Tax Rate—what’s your tax rate? The higher the rate, the greater your tax savings.
If you believe your property might benefit from a cost segregation study, go and discuss your options with a reliable cost segregation service provider.
