Cost segregation is a tax deferral method that preloads capital cost allowances.
For many doctors, ownership is a key part of planning their business. Having your practice in a building you own gives you control of the property and potentially additional income. For example, owning a larger building than you need for your own practice allows you to rent the extra space to someone else and then earn passive income from the rental. However, there are expenses that go along with it, including maintenance, repairs, and taxes. Taxes are inevitable, as the saying goes, but there are ways to mitigate some of the high taxation that can come with ownership. One such solution is cost segregation, which takes advantage of depreciation to analyze a property in a way that can save the owner money.
What is depreciation in real estate?
Everything involved with a property has a natural loss of value through normal use – think of the wear and tear an office will experience daily over the years, from thinning carpets to aging plumbing. Depreciation allows the owner to deduct more taxes by considering this regular wear and tear as a loss in the value of the property. For commercial real estate, the depreciation period is measured over 39 years, a considerable period. When looking at the depreciation of an asset, the entire asset is considered, from that thinning carpet to the building itself.
What is cost separation?
Cost segregation is a tax-deferral method that pre-loads capital cost allowances by breaking down the property into different asset classifications that are subject to their own depreciation timelines rather than taking the property as a whole. Given shorter component depreciation schedules, cost segregation reduces a property’s taxable income at a faster rate, which can maximize tax savings. This is useful for increasing cash flow and reducing taxes, which is particularly beneficial in the early years of ownership.
How does cost segregation work with depreciation?
To start the process, a cost segregation analysis must be performed on the property. This study is conducted by engineers and CPAs, who consider the property and separate it into components, including electrical and plumbing systems, carpets and wall coverings, computers and other specialized equipment, which vary by type of property. Each of the components is measured against its own particular depreciation schedule rather than that of the whole property, which differs from the usual way in which a property’s depreciation is measured. The depreciation periods for these individual components are considerably shorter than the commercial property depreciation period of 39 years, in some cases as short as five years. This shorter timeframe is the result of reclassifying these components as personal property. For property owners, this means writing off more and ultimately paying less property tax.
Since 2017, federal regulations have made the benefits even more attractive to owners, allowing businesses and individuals to deduct a certain percentage of costs in the first year of commissioning. This includes used goods and new goods, and until 2022 the percentage is 100%. With these savings and the resulting increase in cash flow, now may be a good time to buy a property.
How much does it cost?
Although anyone can potentially identify separate assets in a property, as the final report is subject to IRS review, it is important to ensure that professionals carry out the investigation and create the reports to ensuring things are correctly identified for their true value. The costs associated with cost segregation stem from the analysis itself. Depending on the type of property and its size, costs may vary, but the general cost will be between $3,500 and $7,500 per property and will likely take two to three months. This should include the engineer’s visit as well as the final study report.
What does an example look like?
Let’s take the example of a doctor who buys a building for his practice worth $2 million this year. To take advantage of the potential tax savings from accelerated depreciation, he hires a company to perform a cost segregation analysis of the new property. At the end of the study, many assets have a shorter depreciation schedule and the building owner is left with 25% early depreciation. Due to the first depreciation premium, the owner will ultimately write off $500,000 of the purchase price. This means that a taxpayer with a marginal tax rate of 35% would end up saving $175,000 in taxes in the first year. This would justify the expense of cost separation analysis, which is definitely something to consider when deciding if cost separation is the right option.
Can cost segregation for 2021 still be done?
The most effective time for a cost segregation analysis is the year the property was purchased or built. If you made such a purchase in 2021, you can get a cost segregation study to qualify for your 2021 taxes until the April 18, 2022 tax deadline. For prior purchases, you can also do perform a retrospective study at a later date. date and claim the write-offs resulting from the analysis without modifying the tax returns of previous years.
Cost segregation may not make the most sense for every property, but it is a tax-deferral method that can represent significant savings for physicians who own commercial property. Considering this, especially when anticipating real estate purchases for passive or active income, may be in your best interest. As each situation is unique, discuss tax strategies with a financial advisor who will work with you and help you choose the best tools to use for your properties and portfolio in the future.
Syed Nishat is a partner, Wall Street Alliance Group. Syed has been regularly quoted in Medscape, Medical Economics, KevinMD, MedPage Today and Forbes. He can be reached on LinkedIn and on Twitter @syedmnishat.
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