Purchasing real estate is undoubtedly exceedingly costly. but so is renovating a warehouse, store, or home. Luckily there’s this one federal tax planning tool, which real estate investors can use to boost their cash flows when building, renovating, or purchasing a property. Welcome to cost segregation, which for some reason has always remained shrouded in mystery, but not anymore!

What is cost segregation?

If you go by the definition, cost segregation is the practice of breaking down cost line items in real estate to maximize profits and improve after-tax returns. In other words, it is a way for real estate investors to deduct the depreciation of a property – irrespective of it being a single-family home or a commercial space, against their taxable income. This allows them to lower the amount of money they owe to income tax every year!

All that being said, rather than spreading out the depreciation over a long period, the property is categorized into shorter-lived assets, such as land improvements, personal property, and other distinct building components.

How does a cost segregation study work?

Initiating a cost segregation process begins with a cost segregation study – which meticulously outlines how to expedite the depreciation of the property within a single year. Rather than allocating the acquisition cost over a 27.5-year period for residential properties or a 39-year period for commercial properties, cost segregation allows for faster deductions. The positive aspect is that if you qualify as a real estate professional, you can leverage this deduction to reduce your ordinary income. However, it’s important to note that cost segregation can only be applied once on an investment property, so it is advisable to enlist the services of our experts.

1. Feasibility analysis: The process starts with an initial analysis of the investment property, including the finer aspects of it, such as the plumbing fixtures, electrical systems, sidewalks, roofing, flooring, driveway, and more. Chances are, if you bought them separately, the IRS tax code allows them to depreciate over a span of 5 to 15 years. But if they were already a part of the home from the start when you bought it, they’ll depreciate over 27.5 years for residential properties, and 39 years for commercial properties.
2. Gathering information: When you engage a financial firm to conduct the cost segregation study, they will require several property-related documents to complete the assessment. These documents are aimed at determining the value of the property and its various systems and components. The list of necessary documents includes any recent property appraisals, inspection reports, and even the closing documents signed during the property acquisition.
3. Property analysis: Collaborating with a reputable partner is crucial to ensure the job is done correctly. They will identify specific components of your property that can be depreciated over a 5, 7, or 15-year period. This process typically involves a comprehensive review of all available documents related to the property, such as property records, blueprints, and inspection reports.
4. Completing the report: Once all the previous steps are complete, the team will then analyze the property and prepare the final report that determines how much money you save on your taxes through cost segregation.

Key takeaway

The cost segregation method can be particularly handy if you’ve either purchased or built an investment property in the last 15 years, irrespective of whether it’s a residential or commercial space.

At Basta & Company, we take pride in the work we do and have successfully helped hundreds of investors reduce taxes on their property investments over the years. Need any help regarding real estate tax accounting in California? Connect now!