Maximizing your NET income is the name of the game when it comes to income property, isn’t it? There are however two numbers to look at when we’re talking NET - these are the before tax and the after tax numbers.

Taxes have a significant impact on the real dollars in one’s pocket, and minimizing the impact of those taxes, carefully, can go a long way to creating more cash flow. One way to minimize the impact of taxes and maximize cash flow is through Cost Segregation.

What is Cost Segregation?

The National Association of Financial and Estate Planners says this:

A Cost Segregation Study (CSS) (a.k.a. Cost Segregation Analysis) is a financial and engineering-based analysis of all expenditures associated with a property. The objective of the cost segregation study is to properly separate and classify capital expenditures using the shortest life possible based upon IRS specifications and current case law. The cost segregation study uses IRS prescribed engineering based methods to quantify and value assets and place them into their proper asset category. The end result of the cost segregation study is a reclassification of assets that allows for accelerated depreciation and improved cash flow on your property.

From a practical standpoint, what it means is that while investment real estate is depreciated over 39 or 27.5 years (depending on classification) there are many, many pieces and parts of these properties that can be depreciated over much shorter periods of time, say 5, 7, 10, or 15 years. The accelerated depreciation of these components means more money in your pocket sooner.

A cost segregation study should be conducted by a team consisting of engineers and CPAs who specialize in it in order to ensure proper classifications of the various pieces of your property and in order to avoid any trouble with the IRS down the road.

Example

Apartment complex is purchased for $4,000,000.Owners allocate $400,000 of purchase price to non-depreciable land, and depreciate the remaining $3,600,000 over 27.5 years as commercial real property.

Cost Segregation Study The study reveals that 5% ($180,000) of building costs are allocated to 7 year property and 15% ($540,000) to 15 year property.

The study yields an additional $758,000 in depreciation over the first seven (7) years. This additional deferral yields a net decrease in taxes of $294,000 over the first seven years.

The net present value of the tax savings is $164,000(8%) reduction in building cost, for the 27.5 year period.

Should You Do A Cost Segregation Study?

Your property may be a good candidate for a cost segregation study if:

1. You have taxable income
2. You paid upwards of $1M or more for your property
3. You plan on holding the property for several more years