Reducing Tax Liability Through Cost Segregation: What Passive Real Estate Investors Need to Know
For passive real estate investors, maximizing tax benefits is crucial. Yet many are overlooking a powerful financial strategy that could significantly enhance their returns –cost segregation.
Cost segregation can help investors lower their taxes, improve cash flow and enhance ROI.
Let’s explore how it works, how it integrates with historic tax credits, its relationship with the R&D credit, and its potential benefits for reducing capital gains taxes.
What is Cost Segregation?
Cost segregation is an advanced tax strategy that involves separating the cost of a property into different components, each with its own depreciation schedule.
Typically, commercial real estate depreciates over 39 years, while residential real estate depreciates over 27.5 years.
However, certain elements of a property, such as fixtures, equipment, carpeting, parking lots, landscaping, and the like, can be depreciated over five, seven, or 15 years.
By reallocating these costs from long-term assets, investors can accelerate depreciation deductions, which can lead to significant tax savings in the early years of ownership.
Although passive investors are typically subject to limitations on their ability to offset active income with passive losses, cost segregation can still provide substantial tax benefits.
For instance, the savings realized from accelerated depreciation can be used to offset rental income, reducing overall tax liability. This can enhance cash flow and reinvestment opportunities, as well.
Cost segregation is particularly advantageous for investors in high tax brackets or those who own multiple properties.
Using Cost Segregation with Your Historic Tax Credit
Historic tax credits are incentives offered by the government to encourage the preservation and rehabilitation of historic buildings.
These credits can be substantial on their own, and when combined with cost segregation, the tax benefits can be accelerated even further.
When rehabilitating a historic property, cost segregation can be used to separate the costs associated with the renovation into various asset categories.
This allows investors to depreciate certain components of the property more quickly than the building itself.
However, it’s crucial to coordinate the use of HTCs and cost segregation properly. The IRS has specific guidelines to ensure that these credits and deductions are not intentionally disallowed.
To navigate these waters safely, work with a tax professional who understands both the nuances of historic tax credits and the specifics of cost segregation.
By doing so, you can maximize your depreciation deductions without jeopardizing your eligibility for historic tax credits.
Leveraging the R&D Credit
The Research and Development Credit is a federal tax incentive designed to encourage businesses to invest in innovation.
Primarily used by companies engaged in the development of products, processes, or technologies, this credit can also be applied to real estate.
For real estate investors involved in renovation or construction, the R&D Credit can be used to cover some of the costs associated with developing new systems or technologies for building improvements.
Combining R&D credits with cost segregation can further enhance your overall tax strategy, particularly if you’re involved in innovative building projects.
Reducing Capital Gains with Cost Segregation
While cost segregation is traditionally associated with real estate, it can also be used to impact capital gains, particularly in relation to sold stocks.
For instance, if you realize a capital gain from the sale of a stock, the tax savings from cost segregation can be applied to reduce your overall taxable income, thereby mitigating the impact of the capital gains tax.
Furthermore, if you’re involved in a real estate transaction that includes selling a property, understanding how to leverage the tax savings from cost segregation could provide additional liquidity to invest in opportunities that might offer favorable capital gains treatment, such as certain tax-exempt investments.
Is Cost Segregation Right for You?
Cost segregation is a powerful tool for real estate investors seeking to optimize their tax liabilities. By engaging in a cost segregation strategy, you can:
- Increase cash flow: By accelerating depreciation, you can reduce your current tax liability and boost cash flow. This additional cash can be reinvested, enhancing overall returns.
- Improve ROI: The savings from accelerated depreciation can improve the return on investment (ROI) by reducing the upfront tax burden associated with property ownership.
- Defer taxes: Accelerating depreciation allows you to defer taxes to future years. This can be particularly useful if you anticipate being in a lower tax bracket down the road, or if you plan to sell the property at a later date.
Enjoy additional benefits: By combining cost segregation with other tax incentives, such as Historic Tax Credits or R&D credits, you can amplify your financial benefits.