Investing in real estate through syndication can be a great way to build wealth, but understanding the various costs associated with a property can be complicated.
Cost segregation is an important tool that can help real estate investors maximize their profits by breaking down all of the costs related to a property into separate categories and assigning them different tax treatments. This article will discuss how cost segregation works, what it entails, and why real estate syndicators and passive real estate investors should consider incorporating it into their investment strategies.
What is Cost Segregation?
Cost segregation is a tax strategy that real estate syndication attorneys know well. It breaks down the various costs associated with a real estate property into different categories and assigns them different tax treatments. It involves classifying costs in terms of either repairs or improvements, which can differ significantly in terms of their relative cost and the length of time they have to be depreciated.
Cost segregation also allows for identifying and categorizing personal property, which may be eligible for shorter deprecation periods than the other components. By utilizing cost segregation, investors are able to maximize their potential deductions and minimize their taxes on income from investments in real estate.
Land cost segregation
Land cost segregation is a type of cost segregation that specifically focuses on the costs associated with land assets, such as zoning changes, drainage improvements, and other effects related to preparing the land for development. Land costs are often overlooked during cost segregation and can be difficult to categorize as either repairs or improvements. However, they still qualify as real estate-related costs, so it is important to ensure they are included to take full advantage of all available deductions.
Building cost segregation
Building cost segregation is a type of cost segregation that focuses on the costs related to building construction, such as labor, materials, and overhead. Building costs typically take up the largest portion of real estate investments, so it is important to ensure these costs are properly categorized and documented to accurately calculate deductions.
By breaking down all of the various components of construction costs, investors can ensure they are able to fully utilize their full deductive potential when filing taxes on income from real estate investments.
Land improvements (walkway, fence, flooring, etc.)
Land improvements factor into cost segregation by being classified as separate assets with their own associated costs. Since land improvements are typically long-term in nature, they can be deducted over an extended period of time and provide more deductions when filing taxes. Land improvements include things like grading, filling, draining, paving, and other alterations to the land that enhance the economic value of the property. It is important to accurately categorize and document these improvements to maximize real estate investment deductions.
Personal property (washing machine, dryer, furniture, heater, etc.)
Personal property figures into cost segregation by being broken down and categorized as separate assets with their own associated costs. Personal property typically includes items such as desks, chairs, fixtures, machines, tools, and other items of tangible personal property that are used in the operation of a business. By taking the time to categorize these items into individual assets, investors can ensure they are able to maximize deductions when filing taxes on income from real estate investments.
Why Conduct a Cost Segregation Study?
A cost segregation study is an analysis of assets used in a given business operation. The study breaks down the various assets into categories with associated costs, such as land improvements, personal property, and fixtures. Doing so enables investors to maximize deductions when filing taxes on income from real estate investments. Cost segregation studies also allow businesses to better understand their cash flow by providing a more detailed picture of expenses associated with real estate investments.
Related Content: Real Estate Syndication 101
What to Be Wary Of
While cost segregation can help your property investment for tax purposes, there are some downsides to be aware of. The process will entail some cost and time. A study could cost as much as $20,000 or more, depending on the location, age of the property, and whether the building is residential or non-residential.
If personal property is disposed of, there could be depreciation recapture income subject to ordinary rates as high as 35%, plus any state taxes, and possible unrecaptured section 1250 gain, taxed at 25%, again, in addition to state taxes. If a cost segregation study is too aggressive or contains erroneous information, the IRS could assess penalties on the additional tax due to a "substantial valuation overstatement".
Before deciding to invest in a cost-aggregation study to manage your assets with maximum returns, schedule a call with your tax advisor since every property is different. If you put in the research to understand the best way to manage your various assets, the payoff can be enormous.
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