In the ever-evolving realm of real estate taxation, the synergy between cost segregation and bonus depreciation is a powerful catalyst. Despite the changing landscape and the recent reduction in bonus depreciation rates, the strategic alliance between these tools continues to redefine property tax strategies. Here is an insightful exploration into why cost segregation remains a compelling choice for maximizing tax benefits and optimizing cash flow in 2023 and beyond.
Key Takeaways
In smart tax strategies, cost segregations have become a significant change, especially since the 2017 introduction of the Tax Cuts and Jobs Act (TCJA). This approach empowers real estate owners to maximize deductions by accelerating the depreciation of specific property components.
When you acquire a property, it is not just brick and mortar; it encompasses a tapestry of interior and exterior components- it includes various elements like plumbing, carpeting, sidewalks, and more. Remarkably, 20% to 40% of these components qualify for faster tax write-offs than the standard building depreciation schedule. The potency of a cost segregation study becomes evident as a highly effective strategy, enhancing depreciation deductions and alleviating tax burdens for property owners engaged in real estate acquisition or development.
Despite its potential, cost segregation studies often go unnoticed. Many real estate owners, investors, and even tax advisors may overlook this powerful tool simply because they are unfamiliar with its operation and the impactful results it can yield. This blog will delve into how you can benefit from a cost segregation study on your property, emphasizing leveraging bonus depreciation to your advantage and enhancing your cash flow.
Cost segregation stands out as a proven tax-saving strategy for both building owners and tenants handling leaseholder improvements. This approach utilizes accelerated depreciation, allowing taxpayers to enjoy more substantial deductions in the short term instead of spreading them out over the traditional 27.5 or 39-year period permitted by straight-line depreciation. The magic happens by categorizing specific components of a building, shifting them from a 39-year lifespan to much shorter durations of 5, 7, or 15 years. A shorter depreciation life translates to more significant deductions, reducing taxable income and increasing the money lining the pockets of building owners.
Since the 2017 Tax Cuts and Jobs Act (TCJA), cost segregation's advantages have grown. With the TCJA's provision for 100% bonus depreciation, properties with a lifespan of 20 years or less can be entirely written off in the first year. This allows building owners to claim the entire value of accelerated items identified in a cost segregation study in just one tax year, providing immediate benefits and the potential for a substantial tax loss. Any unused tax losses from the current year can be carried forward for future utilization.
In 2023, the bonus depreciation landscape has changed. While 2022 was the final chance for a 100% bonus, it has now dropped to 80%, with a continued reduction of 20% each subsequent year until complete phase-out. Despite this, opting for cost segregation remains sensible.
One enduring strength lies in the immediacy of tax benefits. Despite the absence of the full bonus depreciation percentage, cost segregation enables property owners to swiftly access deductions by accelerating the depreciation of specific components within their properties. This agility ensures that businesses can enjoy prompt relief, fostering enhanced cash flow that can be strategically reinvested or allocated to offset initial investment costs. (More on the example below).
Moreover, the core principle of cost segregation—providing flexibility in asset management—remains unwavering. By categorizing components based on their actual lifespans, property owners retain the ability to tailor depreciation schedules, aligning them with the real-world longevity of assets. This adaptive approach ensures optimal tax efficiency and effective financial planning, irrespective of the specific bonus depreciation rate.
Furthermore, the creation of tax losses, a byproduct of cost segregation, remains a powerful asset. These losses serve as valuable instruments for offsetting alternative sources of income, potentially resulting in a substantial reduction or elimination of income taxes owed.
Cost segregation persists as a multifaceted strategy, offering benefits that extend far beyond the nuances of bonus depreciation percentages. Its ability to accelerate deductions, offer flexibility, and create tax losses makes it a relevant and valuable tool for optimizing cash flow and minimizing tax burdens.
Let us explore a scenario to showcase the advantages of cost segregation:
Meet Sarah, who acquired a commercial property in 2020 for $800,000, where she operates her consulting business. If we follow the standard straight-line depreciation method, Sarah will typically get about a $20,513 ($800,000/39) tax deduction for depreciation on her property. Fast forward to 2023, after a cost segregation study revealed that $280,000 worth of building components could be moved to a 7 and 15-year lifespan. Sarah's tax advisor utilized this revised depreciation schedule to put $280,000 of qualified property into service in 2023.
Given that Sarah's consulting business and the property's rental activities are seen as one economic unit, she could leverage 100% bonus depreciation. In 2023, her consulting business earned $250,000 before factoring in depreciation. With the full utilization of the $280,000 accelerated depreciation, Sarah not only offset her entire income but also created a tax loss, resulting in no income tax payment. The remaining $30,000 loss is carried forward for future use.
This example demonstrates how cost segregation, especially with the added benefit of bonus depreciation, can turn what might be a standard tax deduction into a powerful tool for creating tax losses and optimizing cash flow for building owners.
As depicted in this table, cost segregation delivers significant benefits irrespective of bonus depreciation regulations.
Property owners can increase their overall return on investment by front-loading depreciation deductions through the combined use of cost segregation and bonus depreciation. In comparison to conventional depreciation methods, the property's financial performance is maximized by maximizing deductions in the early years, leading to a higher return on investment.
Property owners can immediately deduct the whole value of qualifying property in the first year of acquisition thanks to bonus depreciation. Significant and instantaneous tax benefits are provided by this immediate full deduction, which enhances cash flow and overall financial flexibility.
Both cost segregation and bonus depreciation often lead to the creation of tax losses. These losses become strategic assets, allowing property owners to offset additional income and potentially eliminate owed income taxes. What adds longevity to this tax-saving strategy is the concept of loss carryovers. Property owners can carry forward any unused losses, extending the timeframe for tax-saving benefits well beyond the current year. This dual mechanism transforms cost segregation and bonus depreciation into enduring tools, providing both immediate relief and sustained, strategic tax optimization over the years.
Cost segregation, in conjunction with bonus depreciation, not only enhances immediate tax benefits but also introduces a layer of adaptability in asset management. Property owners gain the ability to categorize components based on their specific lifespans, allowing for tailored depreciation schedules. This not only optimizes tax efficiency but also facilitates strategic financial planning, aligning with the evolving needs and dynamics of the property portfolio. The synergy between cost segregation and bonus depreciation thus becomes a dynamic tool, offering both fiscal advantages and operational flexibility.
The combination of cost segregation and bonus depreciation acts as an incentive for property owners to make improvements and upgrades to their properties. Knowing they can benefit from accelerated depreciation on qualified assets encourages ongoing enhancements, leading to increased property value and tax advantages.
Conclusion
The ever-evolving landscape of real estate taxation demands a strategic approach, and cost segregation stands out as a timeless tool for maximizing benefits. As we navigate post-bonus depreciation scenarios, it's crucial to recognize that the intrinsic value of cost segregation persists. Beyond its ability to front-load deductions and provide immediate tax advantages, cost segregation offers a flexible and dynamic strategy for aligning with the actual lifespan of assets. The creation of tax losses and the potential for loss carryovers further underscore its significance. A cost segregation study remains a relevant and valuable resource, ensuring that property owners can optimize cash flow and minimize tax burdens in any tax environment.
It is important to emphasize that cost segregation studies should be conducted only by qualified professionals. At Investor Friendly CPA®, we have a team of expert professionals who specialize in evaluating properties, reviewing tax documentation, and preparing comprehensive studies that outline the reclassified assets and their corresponding depreciation schedules. We guide you through the entire process and collaborate with the stakeholders to produce an optimal study to suit your requirements. Our expertise adheres to the guidelines and regulations established by the Internal Revenue Service (IRS), ensuring their validity and providing support in an audit.
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