What Is A Cost Segregation Study?

What is a Cost Segregation Study?

Hi everybody, it’s Todd Wheatley from Candor Realty Boston and Millennium Holding Group. In this video, I’m going to cover what cost segregation is as far as real estate and some of the tax benefits that it can provide to real estate owners and real estate investors. This will be a general overview. It won’t be entirely comprehensive but it’s a good starting point. And if you have any questions, reach out and we can discuss your particular questions or projects in detail.

So, first of all, what is cost segregation? So, I’ve pulled up the definition here on the screen and typically residential multifamily real estate is depreciated over a 27.5 year time period, meaning that the building and all of the components of a building are expected to last 27.5 years and the IRS allows you to depreciate those assets in a straight line fashion, meaning equal amounts each year over 27.5 years.

And so, if you had a property worth one million dollars, excluding the land, you would divide that by 27.5 years and that would be the amount that you could depreciate on your tax return each year, which helps offset any income earned from the property. So, what a cost segregation study is it’s really an engineering based study and it’s used for both new construction projects and existing projects and it breaks down the building and all the components of the building into individual items down to things like the outlet or the sewer line or windows or doors. Every single component of the building is categorized and what that does is that allows for certain components to be put into shorter depreciation timelines. The IRS code allows for certain items with a much shorter life expectancy to be depreciated over 5 years, 7 years or 15 years. And so, by having a compliant engineering firm break down the components of the building, you can move much of your depreciation from 27.5 years to those shorter periods of time, which can have massive tax benefits.

Next, I’m going to actually pull up a real cost segregation report that we completed last year for one of our larger buildings. One thing to note is cost segregation studies, while they’re not always talked about in the real estate investing circles, they aren’t just for big buildings. They’re often used for big buildings because the benefits are quite massive but they can be used on buildings as small as a million dollars or potentially even a little bit less than a million dollars. You would want to talk to the actual cost segregation firm to see if it makes financial sense but because the cost of a study, depending on how many buildings and size, can be as low as $5,000. The tax benefits can be well worth that cost. So, you want to your CPA and you want to talk to your cost segregation team prior to doing it just to make sure it makes sense but you can use these for smaller assets as well.

So, now I’ll pull up an actual report that we used and in this table, you’ll see what the time periods that I was referencing. So, in line one, you’ll see the 27.5 year bucket. Then you’ll see the 15 year bucket and then you’ll see the 5 year bucket. And you can see in the original reported totals, a hundred percent of the property value, the building value, was reported in the 27.5 year line, which means you could have taken this $18.2 million dollars divided by 27.5. And that’s your depreciation each year.

Well, we may or may not own the property for that long. And so, we’d like to benefit from that depreciation much sooner, if possible, to help offset some of our rental income and any appreciation at the time of a sale. So, what we did is we completed this cost segregation study and you can see in the new buckets in the second column. And so, of the $18.2 million original here, $14.2 million stayed in the 27.5 year bucket. $988,000 moved to the 15 year bucket and almost $3 million dollars moved to the 5 year bucket, both computing to the same amount. Obviously, these need to reconcile. The intention is not to add or remove components but to categorize them. So, now that we have these three different buckets and nearly $4 million dollars moved within the 15 year period, I want to move down and show you how that impacts the actual depreciation schedule, particularly in year one, which I’ll highlight right here.

So, before the cost segregation study, we would have been able to take $359,000 of depreciation. That’s because we closed halfway through the year. And so, that would have been the half a year of straight line depreciation, which you can see is the same each year if you follow it down. After this cost segregation study, you can see that we had $4.2 million of available depreciation, which is a net change of $3.9 million in year one and a potential tax savings of $1.5 million in year one. So, what that means is that the owners of the property, and this includes the general partners and investors, would see $3.9 million on their tax return. They would be able to use a portion of that to offset the rental income from the property, which we did in fact see.

And so, that paper loss or the offset in rental income can be used by the owners and investors on their personal returns to help offset ordinary income that they earn from W2 or self-employment or it can be carried over to later years, during which we eventually will sell the building. We could potentially have a significant capital gain. And so, investors and owners of the building may choose to just keep that paper loss in their back pocket to help offset any gains that will be due at the sale of the building. It provides a lot of flexibility. Again, this is not financial advice. This is not tax advice. This is just one real estate investor talking to another but this is one of the very powerful tools that real estate investors can use and have available to them. It’s up to them, their CPA, and their financial planning team to help them understand how best to use this loss within their personal tax situation.

It’s not often talked about but it is one of the more powerful tools that real estate investors have available to them. So, I wanted everybody to know about it. So, with that, if you have questions, reach out or drop a comment below and thanks for watching. Happy investing!

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