You know my philosophy about taxes – they are high, but the government gives us incentives to do what it wants. It’s giving back your money in return for you doing something. Usually that something stimulates the economy, raises income, and increases tax revenue overall. It’s a win-win, and you can’t afford to not take this tax benefit!
We all know that the government looks to tax our income. One way to decrease this tax burden is to claim losses. If we spent a bunch of money to make a bunch more money, we only have to pay taxes on the income over what we spent. Decreasing the effective income is called a deduction. The more you can claim in deductions, the less you have to pay once tax time comes. This isn’t avoiding taxes, it’s doing what the government wants. To claim a deduction, you have to follow rules.
One big deduction is called depreciation, a huge benefit that real estate investors enjoy, and other investments, like stocks, don’t. The government presumes that any real estate you buy which is not land decays slowly over time. A commercial property is considered to become completely worthless after 39 years (residential properties are 27.5 years). Of course, that’s unlikely to happen in real life, but it does for tax purposes. With this, every year, you take a loss of 1/39th of what you paid for the property. This loss offsets income you have and many years means you will have no income after losses on your tax statement. And if you sell, this time resets back to 39 years for the new owner. Amazing!
But, you are a savvy real estate investor. You bought for the right price and you made a bunch of smart improvements. You’ve managed to raise the rent. Now, your income eclipses your losses, and every year you have to pay tax on that income. But wait, what if you had another deduction you could take advantage of?
Enter Cost Segregation
We said that the government says that your property will depreciate to nothing after 39 years. But the property isn’t a monolithic thing. It contains refrigerators, HVAC systems, windows, shingles, and many more things whose lifespan is less than 39 years. The average lifespan of a water heater is 12 years. With cost segregation, you can accelerate the depreciation on a per-item basis, claiming a larger loss early.
Cost Segregation, or cost seg, is a means of dividing up all the parts of your property and assessing them a depreciation time, then depreciating them at that time frame. A 7 year depreciation will depreciate every year at 1/7 of the original value. Don’t know what it originally cost? Your cost segregation expert does, which is why you can’t do it yourself. You have to get an expert to do the cost segregation study. This costs around $10,000. , more or less depending on the property size. You’ll also have more work for your accountant to do, which will cost you more.
Who Shouldn’t Do Cost Seg?
- If you will hold your property for more than the 39 years (27.5 years for residential), you won’t get nearly as much benefit.
- If the property has a very low value, the benefit is lower. Cost seg will run you a lot of money and you might not make it back in tax benefits.
- If you will hold for a very short period you will have to pay back a lot of the taxes saved. When you claim depreciation and then sell (hopefully for a profit), the profit is taxed at a higher rate than capital gains up to the purchase price of the property. This is called depreciation recapture. Holding for a short period may mean you have less taxed at capital gains rate and more at depreciation recapture, which can be up to 25%. This recapture will happen regardless of how long you hold it, but typically you’ll sell for more if you hold it longer, meaning that a higher percentage of your profit is taxed at cap gains than recapture.
Really, you owe it to yourself to do a cost segregation. A good place to start is to ask your accountant for a referral. Do this early in your purchase for maximum benefit.
