Investing in real estate offers significant tax benefits. In particular, depreciation lets real estate investors reduce a property’s taxable income every year without an associated outlay of cash. Due to this “cashless expense” nature of depreciation, investors often have taxable losses while still generating positive cash flows. However, some real estate investors want to accelerate depreciation, taking larger deductions in earlier years. Cost segregation studies serve as one such technique for taking this accelerated depreciation. As such, we’ll use this article to answer the question: what is cost segregation in real estate?
Specifically, we’ll cover the following topics:
- Depreciation and MACRS Overview
- Cost Segregation in Real Estate
- Final Thoughts
Depreciation and MACRS Overview
What is Depreciation?
“Matching” is a fundamental principle of accounting. It argues that businesses should match their expenses to the periods in which they help generate revenue. But, what about longer-term purchases (e.g. equipment, real estate, etc.) that help generate income over multiple periods?
For these purchases, the IRS requires that businesses deduct a portion of the cost over the expected life of the property – a practice known as depreciation. When you purchase an investment property, you cannot deduct the entire acquisition cost in the first year. Instead, the IRS allows you to depreciate the portion of that cost allocated to improvements (you cannot depreciate land) over a period of time. In this fashion, you “match” the acquisition costs against the income generated in each year of the property’s operations.
In other words, depreciation allows you to reduce an investment property’s taxable income over a period of multiple years. And, as this depreciation expense doesn’t include an annual cash outlay, it often allows real estate investors to claim a taxable loss while a property still generates positive cash flow. Great benefit!
The IRS and MACRS Depreciation
But, as with all tax benefits, the IRS mandates specific depreciation rules to avoid abuse. Most importantly, the IRS has implemented the Modified Accelerated Cost Recovery System, or MACRS (pronounced “makers”), to dictate the methods and periods over which property should be depreciated.
For example, MACRS states investors depreciate residential real estate over a period of 27.5 years. For example, say you purchase a duplex for $500,000, and you allocate $400,000 of that purchase to the actual property improvements (with the remaining $100,000 allocated to land and not depreciable). With this $400,000 depreciable basis, you could claim $14,545 in annual depreciation expense ($400,000 divided by 27.5 years).
However, MACRS doesn’t just provide depreciation guidance for real estate. It also includes all other classes of depreciable property. For instance, MACRS states that office furniture and fixtures in a building have a useful life of seven years, allowing investors to take far faster depreciation than residential real estate.
Cost Segregation in Real Estate
What is Cost Segregation?
These different cost categories – and associated depreciation schedules – create an opportunity for real estate investors to accelerate depreciation. Rather than roll all of a building’s costs into the 27.5-year residential real estate category, a cost segregation study breaks down every component of a building into its correct MACRS cost category.
For example, cost segregation studies list building fixtures – which could total tens of thousands of dollars (or more) – in the above 7-year MACRS category, not the 27.5-year one. This allows investors to depreciate those components far more quickly, significantly reducing taxable income in earlier years of a property’s holding period.
Cost Segregation Example
To illustrate the potential tax-saving power of a cost segregation study, we’ll continue the above example of the $500,000 duplex purchase. We still allocate $100,000 to land, with the remaining $400,000 your depreciable basis. But, a cost segregation study identifies $50,000 of that $400,000 as fixtures, qualifying those costs for 7-year MACRS depreciation.
Without a cost segregation study, your $400,000 depreciable basis qualifies for $14,545 in Year 2 depreciation (to ignore the additional calculations for Year 1 depreciation). But, with $350,000 applied to 27.5-year depreciation and $50,000 to 7-year, double-declining balance depreciation (the 7-year convention), your total Year 2 depreciation expense increases to $24,972 ($12,727 in 27.5-year plus $12,245 in 7-year depreciation).
In other words, by conducting a cost segregation study, you could claim an additional $10,427 in Year 2 depreciation!
Final Thoughts
We only scratched the surface of cost segregation technical details in the above article. But, the important takeaway for real estate investors is that cost segregation studies can significantly accelerate your depreciation expense, allowing you to take far larger deductions in the early years of a property’s hold period.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated tax implications.