This year’s most interesting tax season observation has to do with a strategy available for people who own real estate that helps them save more taxes in the early years. As the price of real estate continues to increase, more business property owners are having Cost Segregation Studies completed.
According to our friends at MS Consultants (www.costsegs.com), Cost Segregation is a process approved by the IRS that accelerates the depreciation you can claim on business real estate you own.
A Cost Segregation study allows real estate owners to break down the capitalized costs of their buildings and identify those building costs that can be depreciated over much shorter periods of time than the 39 years generally assigned to non-residential real estate. Non-structural elements of buildings such as doors, cabinets, and carpeting, and even walkways and other “land improvements” can be depreciated over 5 to 15 years. It makes sense logically: your carpet isn’t going to last for 39 years, why should you depreciate its cost over that period of time?
To make Cost Seg studies even more valuable, the IRS still allows for “bonus depreciation” which provides real estate owners with the opportunity to claim substantial first-year deductions based on the cost of those assets determined to have a life of 20 years of less. If you own real estate including the office space for your practice, completing a Cost Seg study could lead to thousands of dollars in tax deferments. This, in turn, could equate to a substantial influx in available cash thanks to the associated decrease in your current-year tax liability. An engineering-based study conducted by a specialty firm such as MS Consultants provides a clear set of documentation in the case of an audit.
Let’s look at an example where you purchase a building for your practice that costs $1.5M with $500k of that cost assigned to the value of the land which isn’t depreciable. Without a Cost Seg study, you would claim depreciation of $25,641 ($1M / 39 years) annually on the non-land cost basis of $1M.
What happens if you obtain a Cost Seg study for the new building, and the analysis supports that the fixtures and other non-structural elements are worth $170k and the land improvements are worth $50k? In this example, you would write off most of the total cost of $220k ($170k + $50k) in the first year with the remainder during the following 5 to 15 years, while your annual deprecation on the remaining building cost decreases to $20k ($780k / 39 years) per year going forward.
The money the Cost Seg study puts in your pocket is the extra depreciation you would save up front multiplied by your marginal tax rate – about $80k in this example. The real value of the Cost Seg study, however, is the compounded returns you can earn on that $80k by purchasing more real estate, paying down debt, or making other investments. Remember, you do pay back the upfront depreciation claimed over the remaining 39-year life of the building by taking a smaller depreciation deduction each of the subsequent years. In this example, the depreciation deduction falls by $5,641 annually; from $25,641 without a Cost Seg study to $20k after the study.