How Real Estate Investors Can Improve Tax Benefits Through Cost Segregation in 2023

Real estate investors have many tax benefits available to them if they know where to look. Cost segregation is a potent tool for amassing more tax deductions earlier in a project. By breaking the costs of a development or construction project into separate assets, investors can speed up their depreciation schedules. Rather than depreciating the entire project over decades, they can depreciate some assets over a period of a few years. Under current tax law as of 2023, the depreciation period could be shorter than that. This article defines cost segregation and outlines how it can provide tax benefits for certain real estate investors.

What is Cost Segregation?

Cost segregation accelerates depreciation for assets involved in a real estate development or construction project. The IRS uses the modified accelerated cost recovery system (MACRS) to determine how taxpayers must depreciate assets. Most assets use the General Depreciation System (GDS), while some may be subject to the Alternative Depreciation System (ADS). When a parcel of real estate is treated as a single asset, the depreciation periods under GDS are:

  • Residential rental property: 27.5 years
  • Nonresidential real property: 39 years

Under ADS, the periods of depreciation can be longer. Real estate investors can speed up depreciation and reduce their annual tax bills through cost segregation. This process breaks down the project into separate classes of depreciable assets. For cost segregation to pass the IRS’s standards, an investor must have a cost segregation study conducted by someone with both financial and engineering expertise.

Cost Segregation Study

A cost segregation study will analyze the property and the project to see what types of depreciable classes might apply. It will look at all nonstructural components of a project, such as appliances and infrastructure. For new construction, the study might consider all of the steps in the construction process and all of the components used. A study for a home renovation project might have a narrower scope. A complete report will be necessary to justify the various depreciations claimed on the investor’s tax return.

Depreciable Classes

Federal tax law provides numerous classes of property for depreciation purposes, with periods from three to 25 years. The class of “five-year property,” for example, includes:

  • Office machinery;
  • Research and experimentation equipment;
  • Appliances used in residential real estate; and
  • Certain types of renewable energy equipment.

By separating some costs of a real estate investment project into different depreciation classes, investors can deduct those costs faster than the standard depreciation schedule for real property would allow.

Bonus Depreciation

The Tax Cuts and Jobs Act (TCJA) of 2017 significantly expanded the bonus depreciation deduction, also known as the 168(k) allowance. Prior to the bill’s effective date, taxpayers could deduct 50% of the cost of certain assets during the year they placed them into service. For qualified property placed into service after September 17, 2017 and through the end of 2022, the deduction amount was 100%. In 2023, the deduction is 80% of the cost of the qualified property. The remainder of the cost is subject to depreciation over the regular length of time for that asset. The bonus depreciation deduction has begun to phase out. It will go down by 20% each year until 2027, when it will reach zero.

What Properties Are Eligible for Cost Segregation?

Businesses typically cannot claim the entire value of major assets as tax deductions in the year they acquire those assets. Instead, the asset becomes a capital account and they write off the asset’s value over time in a process known as “depreciation.” Currently, § 179 of the IRC allows taxpayers to claim up to $1 million of a new asset’s value as an expense, rather than a capital account, during the year they place the asset in service. The SBJA would increase this amount to $2.5 million. Almost any type of property except for an investor’s primary residence may be eligible for cost segregation. The exact type of cost segregation will depend on the property, the nature of the project and its nonstructural elements.

When Can Investors Use Cost Segregation?

An investor can begin to use cost segregation at any time during a project, provided they have completed a cost segregation study. If the project is already underway, they can speed up an ongoing depreciation schedule by filing a notice with the IRS that they are changing to a new accounting method.

Who Can Benefit the Most from Cost Segregation?

Cost segregation provides additional tax deductions on a year-to-year basis. The more actively involved a real estate investor is in a project, the more benefits they are likely to see from cost segregation.

What Are the Risks of Using Cost Segregation?

While using cost segregation does not, by itself, appear to make an IRS audit more likely, it raises issues that an auditor will closely examine if an audit does occur. Investors who have used cost segregation without a thorough study may risk audit challenges.

Learn More About the Benefits and Risks of Cost Segregation

Real estate investing can be quite lucrative, but it can also be expensive and bring complicated tax filing obligations. Cost segregation can be a great way for investors to save on their tax bills, but they must proceed carefully. A tax professional with experience in cost segregation can help identify the best path forward

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