There are many reasons why people are attracted to real estate investing – it’s exciting, interesting and challenging, to name a few – but there’s one key motive for staying in the business: There’s a lot of money to be made. Despite the objective to maximize ROI, investors often don’t fully leverage the ways they can increase returns on investments. There are several tax strategies that – when applied with the help of a seasoned advisor – can help investors save up to hundreds of thousands of dollars. Most advisors will start with cost segregation to quickly yield returns and increase cash flow for clients.
What is cost segregation?
In sum, cost segregation is a tax strategy that identifies and reclassifies property to accelerate depreciation for reduced tax obligations. More specifically, cost segregation identifies building costs that would typically be depreciated over a 27.5- or 39-year period and reclassifies them to permit a shorter, accelerated method of depreciation for certain building costs. For example, costs for non-structural elements, such as wall covering, carpet, accent lighting, portions of the electrical system, and exterior site improvements such as sidewalks and landscaping, can often be depreciated over five, seven or 15 years, rather than over 27.5 or 39 years.
Why does this matter? By shortening the asset’s life, the investor is able to accelerate the depreciation expense to reap the tax benefits in the early stages of the asset’s life. Since the average investor hangs onto a property for only 7-10 years, it enables them to reap the same tax benefits over that period of time that they’d otherwise stretch out over decades.
If you’re not taking advantage of cost segregation, you’re leaving money on the table – and doing your real estate investment portfolio a huge disservice. Leveraging cost segregation tax strategies can increase returns by up to 15% — and when you’re talking about multi-million dollar assets, 15% adds up to hundreds of thousands of dollars. This increased cash flow can be used to pay for up-front costs on an existing property or as capital to secure loans for additional investment properties.
What does cost segregation look like in practice?
One of my clients, John, recently purchased a multi-family home in Cambridge for $1.5 million. After renovations and upgrades, he plans to rent out three units at $3,000/month each; in 7 years, he’ll evaluate the market and determine if the time is right to sell. To maximize John’s long-term gain over this time period, we decided to leverage cost segregation according to the following timetable:
Thirty-five percent of the purchase price is properly allocable to 27.5-year property, 15% to 15-year property, 45 percent to seven-year property, and 5% to five-year property.
|Asset Class||Cost||1st-year depreciation|
|Straight line method||$38,182|
By leveraging this tax strategy, John quickly increased his cash flow and has access to an additional $60,000 that he plans to use as capital to secure a loan on another multi-family investment property in the Greater Boston area.
Make cost segregation work for you
Whether you’re a one-off, first-time real estate entrepreneur or an institutional investor, implementing a cost segregation analysis ensures that you’re maximizing your returns as quickly as possible. And not only is it a legal tax strategy, but the U.S. government actually encourages real estate investors to leverage cost segregation tax breaks as a means to stimulate to economy. To ignore these tax benefits is basically just leaving money on the table.
That said, tax law is complicated and the ramifications of missteps on your tax return are significant. It’s imperative that you engage with an advisor who has the expertise to guide you through the process and complete your cost segregation analysis. This will ensure that you’re not only maximizing your returns, but that you’re doing it correctly and legally.
To learn more about how cost segregation can work for you and your investment portfolio, please reach out email@example.com and we can set aside some time to discuss your situation and options.