Cost segregation is a tax deferral method that front-loads the depreciation deductions.
For many physicians, owning property is a key part of their business planning. Having your practice in a building you own gives you control over the property, and potentially additional income. For instance, owning a building that is larger than you need for your own practice allows you to rent the extra space to someone else and then make the passive income from the rental. However, there are expenses that go along with that, 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 property ownership. One such solution is cost segregation, which takes advantage of depreciation to analyze a property in a way that can save an owner money.
What is depreciation in real estate?
Everything involved in a property has a natural loss of value due to normal use—think the wear and tear that an office will take on a daily basis over the years, from thinning carpets to aging plumbing. Depreciation allows the property owner to write off more for taxes by considering that regular wear as loss of property value. For commercial property, the length of time for depreciation is measured over 39 years, a considerable length of time. When looking at depreciation of property, the entirety of the property is taken all together, from that thinning carpet to the building itself.
What is cost segregation?
Cost segregation is a tax deferral method that frontloads the depreciation deductions by breaking the property down into different asset classifications that are subject to their own depreciation timelines rather than taking the property as a whole. Taking into account the components’ shorter depreciation schedules, cost segregation lowers the taxable income of a property at a quicker rate, which can maximize tax savings. This is helpful to increase cashflow and reduce taxes, which is especially beneficial in the early years of ownership.
How does cost segregation work with depreciation?
To start the process, a cost segregation analysis must be done on the property. This study is conducted by engineers and CPAs, who consider the property and separate it out into components, including electrical and plumbing systems, carpeting and wall coverings, computers and other specialized equipment, which will vary by property type. Each of the components is measured against its own particular depreciation schedule rather than that of the whole property, differing from the usual way depreciation for a property is measured. The depreciation times for these individual components is considerably shorter than the 39 year commercial property depreciation timeline, in some cases as short as five years. This shorter time is the result of those components being reclassified as personal property. For property owners, this means writing off more and ultimately paying lower taxes on the property.
Since 2017, federal regulation has made the benefits even more attractive for property owners, allowing both businesses and individuals to deduct a certain percentage of costs the very first year they’re in service. This includes used as well as new property, and through 2022, the percentage is at 100 percent. With these savings and the resulting increased cash flow, it may be a good time to purchase property.
How much does it cost?
While anyone could potentially identify separate assets in a property, as the final report is subject to IRS review, it’s important to ensure you have professionals conducting the survey and creating the reports to make sure things are identified correctly for their true value. The fees associated with cost segregation stem from the analysis itself. Depending on the type of property and its size, the costs can vary, but the general cost will range between $3500 and $7500 per property and will likely take two to three months to complete. This should include the engineer walk through as well as the final report of the study.
What does an example look like?
Let’s consider a physician who purchases a building for his practice worth $2 million this year. To take advantage of potential tax savings due to accelerated depreciation, he engages a firm to do a cost segregation analysis of the new property. Upon the completion of the study, many of the assets have a shorter depreciation schedule, and the building owner ends up with 25% in advance depreciation. Because of the first bonus depreciation, the owner will ultimately write off $500,000 of the purchase price. That means that a taxpayer with a 35% marginal tax rate would end up saving $175,000 in taxes that first year. This would make it worth the fees for the cost segregation analysis, which is definitely a consideration when deciding whether cost segregation is the right option.
Can cost segregation for 2021 still be done?
The most efficient timing for a cost segregation analysis is in the year that the property was purchased or constructed. If you made such a purchase in 2021, you may get a cost segregation study done to qualify for your 2021 taxes until the tax deadline on April 18, 2022. For past purchases, you can also have a look-back study done at a later date and claim those write-offs that result from the analysis without amending prior-year tax returns.
Cost segregation may not make the most sense for every property, but it is a tax deferral method that can add up to significant savings for physicians who own commercial property. Considering it, particularly when anticipating property 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 decide the best tools to use for your properties and your 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 & Forbes. He can be reached on LinkedIn and on Twitter @syedmnishat.
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