Building Wealth Brick by Brick | How Cost Segregation and Bonus Depreciation Elevate REI Profits
When it comes to real estate investment (REI), savvy investors are always on the lookout for strategies to optimize their returns and minimize their tax burdens. Two such valuable tools that can significantly impact a real estate investor's bottom line are Cost Segregation and Bonus Depreciation.
What is Cost Segregation?
Cost Segregation is a tax planning strategy that allows real estate investors to accelerate the depreciation of certain property components. Typically, the IRS assigns a fixed depreciation period for an entire asset ranging from 27.5 years for residential properties and 39 years for commercial properties. However, Cost Segregation allows investors to reclassify depreciation for various elements of the building, such as the structure, electrical systems, appliances, and plumbing into shorter depreciation periods, typically 5, 7, or 15 years.
How Does Cost Segregation Work?
To benefit from Cost Segregation, investors enlist the expertise of a qualified Cost Segregation specialist, such as an engineer or tax professional, who conducts a thorough analysis of the property. The specialist identifies specific components that can be reclassified.
For example, elements like roofing, flooring, appliances, HVAC, and more qualify for a shorter depreciation schedule. By accelerating the depreciation of these components, investors can deduct larger depreciation expenses in the early years of property ownership, leading to a reduction in taxable income and increased cash flow.
The Advantages of Cost Segregation
Increased Cash Flow: By front-loading depreciation deductions, Cost Segregation boosts cash flow in the initial years of ownership, providing investors with additional funds for reinvestment or other purposes.
Tax Savings: Cost Segregation results in reduced taxable income, leading to lower tax liabilities.
Improved ROI: With greater cash flow and tax savings, the return on investment (ROI) is significantly enhanced over the holding period.
The property is owned by the taxpayer looking for tax benefits.
It qualifies for depreciation under the U.S. tax system (MACRS).
It was built, bought, or renovated after 1986.
The taxpayer has taxable income to benefit from the tax savings.
The project cost is usually $500,000 or more, so the tax benefits outweigh the cost of the study.
A cost segregation study generally takes four to eight weeks, from the time you start collecting relevant information to the time you review your tax position.
Bonus Depreciation: A Powerful Complement to Cost Segregation
In addition to Cost Segregation, real estate investors can further enhance their tax benefits by leveraging Bonus Depreciation. The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a significant change in Bonus Depreciation rules, allowing investors to deduct 100% of certain capital improvement costs in the first year they are placed in service.
Now, The 100% bonus depreciation in real estate only lasted until the end of the 2022 tax year. The bonus depreciation phases out through 2026 in 20% per year reducing increments. For example in 2023, it is 80% bonus depreciation.
One of the keys to claiming bonus depreciation is understanding the difference between a repair and an improvement. For tax deduction purposes, the cost of a repair is generally deducted from gross rental income the same tax year the cost was incurred. Repair expenses include work that keeps a rental property in good condition, such as painting a room, fixing a leaky sink, or cleaning the carpet in between tenants. By contrast, an improvement is something that betters, adapts, or restores a property.
Depending on the scenario, when an investment property is sold, depreciation may be subject to recapture and taxed the same way that other forms of depreciation are. Recaptured depreciation is taxed as regular income, but only up to a maximum rate of 25%. In other words, if an investor is in an upper-income tax bracket of 32% or more, depreciation recapture tax is capped at 25%. There are many many intricacies to depreciation recapture, so talk to your tax professional about specifics.
Combining Cost Segregation with Bonus Depreciation
The tax benefits can be truly remarkable when Cost Segregation and Bonus Depreciation are used in tandem. By accelerating depreciation through Cost Segregation and then claiming Bonus Depreciation on qualified assets, investors can achieve a substantial reduction in taxable income, leading to significant tax savings.
For real estate investors seeking to optimize their returns, Cost Segregation and Bonus Depreciation are invaluable tools. By unlocking the tax-saving potential of these strategies, investors can boost their cash flow, improve their ROI, and ultimately, build a more profitable real estate investment portfolio. However, it is crucial to consult with a qualified tax professional or financial advisor to ensure compliance with tax laws and to tailor the approach to individual investment goals and circumstances. So, whether you are a seasoned investor or just getting started, exploring the benefits of Cost Segregation and Bonus Depreciation could be a game-changer for your REI journey.
This is not tax or legal advice. We are not certified tax professionals or lawyers.