Commercial real estate investments require strategic planning to optimize returns and manage tax liabilities. Cost segregation is a powerful financial strategy that can significantly impact the financial performance of commercial real estate properties.
Let’s explore the concept of cost segregation, its benefits, and how it can enhance the returns on commercial real estate investments. If you’re interested in adding cost segregation to your financial strategy, request a free proposal now.
Table of Contents
What is cost segregation?
Cost segregation is a tax strategy that allows accelerated depreciation of certain components of a commercial property. This is done by identifying and reclassifying these components.
For example, where buildings are generally depreciated over 27.5 or 39 years, cost segregation allows investors to allocate certain costs to shorter recovery periods, such as 5, 7, or 15 years. This allows investors to generate bigger tax deductions in the earlier years of ownership, which in turn improves cash flow and overall returns.
Key components
Cost segregation works by breaking down the overall cost of a commercial property into specific components which are called key components. Examples of key components that are subject to cost segregation are personal property, land improvements and building components.
Personal property would be things that have a shorter useful life than the actual building such as furniture or light fixtures. Land improvements such as parking lots or sidewalks often have shorter recovery periods. These are things that exist around the building but that are not part of the building itself.
This is not to say that things that are not part of the building cannot be key components. Certain structural elements such as roofing and electrical systems may also qualify.
Benefits of cost segregation
Cost segregation allows for increased cash flow by accelerating depreciation deductions. This results in higher depreciation expenses in the earlier years of ownership and can lead to higher tax deductions early on which ultimately improves cash flow.
Cost segregation also enhances the property’s overall return on investment (ROI) if the increased cash flow generated from tax savings is used correctly. If additional cash flow is reinvested or used to pay off debt, it could contribute to a better ROI.
The same can be said for increased cash flow due to tax deferral. Cost segregation allows investors to defer taxes by reducing their taxable income through accelerated depreciation. This is particularly beneficial for those looking to reinvest in additional real estate projects.
Cost segregation studies that are properly executed provide a detailed breakdown of the property’s components and their respective values. This can be beneficial when refinancing or selling the property, potentially increasing its perceived value and attractiveness to potential buyers or lenders.
Tax regulations
It is important that Cost segregation studies adhere to the guidelines set forth by the Internal Revenue Service (IRS). Compliance is not only necessary in order to realize the full benefits of cost segregation but also to avoid any potential tax-related issues.
Implementation
Cost segregation is most effective when performed shortly after the acquisition or construction of a commercial property, making timing important. Although, all is not lost if it is not done at this time, as it can also be applied at a later stage by using a “catch-up” adjustment.
The suitability of cost segregation also depends on things like property type, size and cost of construction. These need to be thoroughly evaluated to determine the benefits for a specific property.
Ultimately, for cost segregation to be implemented effectively one is required to collaborate with qualified professionals who are experienced in identifying which assets are eligible and to help navigate complex tax regulations.
Cost segregation is therefore a valuable tool for commercial real estate investors that are seeking to optimize returns and manage tax liabilities. By accelerating depreciation and increasing cash flow, cost segregation can enhance the overall financial performance of a property.
As with most tax strategies, engaging with qualified professionals to ensure compliance with regulations and to maximize the benefits of cost segregation is a must.
