What is Cost Segregation in Real Estate Investing?

Positive cash flow gives investors and business people two clear advantages. One, it puts more money directly into your pocket. Two, it gives you plenty of financial freedom for the future. When it comes to cost segregation, you get the best of both worlds – sometimes resulting in a huge cash advantage.

Segregation is generally a bad thing when it comes to life in the bigger picture but when it comes to money, segregation can be a very good and profitable thing. With the cost segregation concept in real estate it applies to multifamily rental units, as opposed to single family dwellings. These are properties you are using to make a profit on, and while the potential profit can be significant there is always tax time to consider. Here is where cost segregation can be your best financial friend.

Let’s use an example as a reference point. You own a multifamily unit that has an assessed value of $400,000 for tax purposes. That amount is considered as a property that is allowed to be depreciated over a 27.5 year period based on the MACRS method of accounting. But instead of treating the property as a single asset class you can use cost segregation and divide it into several different asset classes, which will allow you to accelerate your depreciation. If you plan your taxes properly you can reduce some assets down to a 5 year depreciation period. This will increase your cash flow and free you to sell the property earlier should you choose to do so.

Using our example, you have the following assets:

  • Kitchen stoves
  • Lawn sprinklers
  • Carpeting
  • Parking lot

There are many other items you can include on the list that will fit into other asset categories. These are just a sampling. The parking lot and lawn sprinklers will go into the Land Improvement category, while the kitchen stoves and carpeting will be placed in Distributive Trades and Services. The parking lot and sprinklers can now be depreciated over a 15 year period, while the stoves and carpeting can be depreciated for a mere 5 years.

All totaled, your accumulated depreciation can increase from less than $4,000 under the 27.5 year assessment to more than $160,000 using cost segregation. That puts roughly $155,000 more in your cash flow for the reportable tax year. This very basic example makes it well worth your time and effort to find out what parts of your multifamily unit property can be segregated and planed in a different asset category to accelerate your MACRS depreciation.

So there is the immediate advantage of the reclassification of your assets by increasing your depreciation and cash flow, and the long term advantage of being able to free yourself for the sale of the property after the depreciation periods run out. In the example, you no longer have to wait out more than 27 years before you can maximize the advantages of owing real estate but instead can realize some of those advantages in a short 5 years. The middle range is 15 years, just over half of the time allowed under the non-cost segregation method.

The question is whether this actually works to your long term advantage for your particular situation. You might be in a situation where you want to slowly depreciate the entire property because you have a number of other passive income sources that are generating significant profits. Thus the tax advantages of cost segregation may be delayed, if possible, for a future date when cash flow becomes a major issue. Most investors are not in such a position, but it is important to conclude that cost segregation is not always the best course of action.

On the flip side of the issue, if you know you will be selling your multifamily real estate property within the next 10 or 5 years, it is hard to find a reason why you wouldn’t apply the advantages cost segregation offers. If you are seeking to move on from your existing property you may be able to use the accelerated depreciation method to accelerate your purchase of a second property years ahead of schedule. There are a significant number of tax implications and bottom line dollar considerations to evaluate, so be sure to consult your investment advisor or tax professional before making any final decisions.

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