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  • Writer's picturePetr Fesyuk, CPA, EA

Is Cost Segregation Strategy for you?

If you're a rental real estate owner, understanding cost segregation studies can be a game-changer. This article delves into what these studies entail, how they operate, and who stands to benefit. A cost segregation can be a key to unlocking tax savings.

Imagine a cost segregation study as a way to fast-track a "loan" from the IRS. Sounds intriguing, right? Essentially, conducting a cost segregation study allows you to front-load a significant portion of depreciation in the initial years. This results in accelerated tax benefits, lowering your taxable income and leaving more money in your pocket. While opting for this method has clear advantages, it's crucial to consider potential drawbacks. Heavy depreciation can reduce the property's cost basis, leading to recapture when you eventually sell. In essence, cost segregation can be likened to a loan that needs repayment.

Implementing a tax strategy like this requires careful planning, as it's not a one-size-fits-all approach. Here are signals that a cost segregation study might be suitable for you:

  1. High Tax Bracket: If you're in a tax bracket exceeding 24%, a cost segregation study could be highly beneficial, resulting in substantial savings through property depreciation.

  2. Significant Rental Income: For those with substantial rental income, a cost segregation study can notably decrease your tax liability, especially when other property-related deductions are running thin.

  3. Recent Property Sales: If you've recently sold properties and generated significant gains, leveraging substantial depreciation from cost segregation studies can offset these gains.

  4. Purchase Prices Over $375,000: Larger properties tend to benefit more from cost segregation studies, with optimal advantages starting around the $375,000 purchase price threshold.

  5. Material Participation: If you can actively participate in managing your property, a cost segregation study is likely to be beneficial.

However, there are scenarios where cost segregation studies may be inefficient if:

  1. Lower Tax Brackets: In years with lower tax brackets, increased depreciation may have minimal impact on reducing taxable income. It might be more prudent to defer the study to a year when you surpass the 24% threshold.

  2. Little to No Rental Income: Limited rental income won't yield the same advantages from heavy depreciation.

  3. High Land to Building Value: Properties where the land holds a substantial portion of the value may not benefit significantly from cost segregation, as land is not depreciable.

  4. Short-Term Properties: If selling the property is imminent, cost segregation might not be worthwhile, as recapture will occur at the time of sale.

The essence of this method revolves around the time value of money – utilizing savings today to generate more income for the future and cover future tax bills.

If you're intrigued by the idea of a cost segregation study, it's essential to address a few lingering questions:

Does it make sense for a property with a lower purchase price? Yes, depending on the property's building-to-land ratio and other signals mentioned earlier.

When should the study be conducted? Ideally before filing taxes, and the earlier, the better for more detailed calculations.

Can it be done on an already-owned property? Certainly! Cost segregation studies don't need to be done in the first year and can be applied to existing real estate investments.

However, caution is necessary, particularly with DSCR loan properties, as prepayment penalties and depreciation recapture taxes could intersect. Additionally, properties in restrictive areas like HOAs or communities might pose challenges if rules change.

In conclusion, a cost segregation study, like many tax strategies, can be advantageous when implemented correctly. Understanding the strategy and integrating it with other tax-saving approaches can result in substantial savings throughout your real estate investing career. If you find this information useful, explore other strategies and consider scheduling a call with our team to explore how we can help you navigate the complexities of real estate taxation.

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