Unlocking Tax-Free Wealth: How Cost Segregation Supercharges Your Real Estate Returns

Have you ever wondered how top real estate investors seem to pay little or no taxes? One of their most powerful strategies is cost segregation. Although it may sound complicated, it’s actually a straightforward way to reduce your tax bill and increase your cash flow.

Having said that, this post features insights from Wes Mabry, founder of 1245 Consulting and one of the country’s leading authorities on cost segregation. With over 17 years of experience, Wes has saved clients over $2 billion in taxes, ranging from small landlords to ultra-high-net-worth investors.

Let’s take a closer look at cost segregation and explore how you can utilize it to your advantage.

What is Cost Segregation?

“Cost segregation” refers to reclassifying real estate components from long-term to short-term assets for tax purposes.

According to the IRS, residential properties must be depreciated over 27.5 years, while commercial properties are depreciated over 39 years. This is a slow and methodical process known as straight-line depreciation. With cost segregation, items within a property have a shorter “useful life” and can be depreciated much faster – typically in five, seven, or fifteen years. By doing this, you create significant “paper losses” on your tax return without having to spend any money.

Think of it this way: instead of treating your whole $1 million property like a single asset that loses value slowly, you can break it down into smaller parts. By doing this, you’re separating the building’s main structure from items such as carpet, specialized plumbing, landscaping, and parking lots, which depreciate much faster.

Why Accelerated Depreciation Matters

According to Wes, depreciation is often misunderstood. It’s not a real expense since you’re not writing checks for it. Instead, accountants use it to determine if assets are losing value over time.

Accelerating depreciation doesn’t deduct actual costs; it offsets real income by using non-cash expenses. In other words:

• You still earn rental income from your property.
• In the first year, you take a huge paper loss.
• Your tax liability is reduced or eliminated as a result of that loss.

Let’s say you want to buy a $1 million property for $200,000 down and $800,000 financed. With cost segregation, you can often deduct hundreds of thousands of dollars in the first year. You can nearly match your down payment with that kind of tax savings.

Examples of Accelerated Depreciation

The depreciation of each part of a property is different. As Wes explains, during a cost segregation study, a property is broken down into categories, with certain items being classified as having a shorter “useful life.”

• 5-year property. These include carpeting, vinyl flooring, cabinetry, signage, specialized electrical or plumbing systems, as well as equipment specific to the company.
• 15-year property. Landscaping, pavers, irrigation systems, drainage, and outdoor lighting are examples of land improvements.
• 39-year property. In terms of the building structure itself, it cannot be accelerated beyond the standard schedule.

An example would be the reclassification of kitchen gas lines, point-of-sale systems, and ventilation equipment as 5-year property for a fast-food restaurant. Landscapes, parking lots, and drainage systems could be reclassified for a period of 15 years. If there weren’t cost segregation, all this would gradually depreciate over nearly four decades.

Bonus Depreciation: Turbocharging the Strategy

In addition to accelerated depreciation, investors can deduct a large percentage of certain assets in the first year by using bonus depreciation.

Since 2017, bonus depreciation has applied not only to new construction but also to used properties. In turn, countless investors will benefit from this. Over time, the percentages have shifted:

• 100% bonus depreciation (2017–2022)
• 80% in 2023
• 60% in 2024
• Scheduled to phase down further unless extended by Congress

Any asset with a life expectancy of less than 20 years qualifies for bonus depreciation. As a result, properties identified in a cost seg study and identified in a 5-year and 15-year study will see massive write-offs in their first year.

Even at 60%, the impact is significant. Taking the $1 million car wash example again, $850,000 is eligible for depreciation after land value is stripped out. Despite investing only $200,000 of your own money upfront, you could still incur a first-year paper loss of around $500,000 due to cost segmentation and bonus depreciation.

Which Properties Benefit Most?

While almost all income-producing properties can benefit, some are better candidates than others. Generally, as Wes states, specialized properties depreciate faster.

• Top performers. These properties include car washes, mobile home parks, specialized manufacturing facilities, and medical offices. Almost all components of these types of properties can be reclassified into shorter depreciation schedules.
• Moderate performers. An apartment complex, a retail center, and a bank are examples of standard properties. Although they still benefit significantly, reclassification is less likely for them.
• Lower performers. Buildings with no interior components or land improvements, such as warehouses or condos.

Retroactive Cost Segregation: Can You Look Back?

If you already own a property, but didn’t conduct a cost segregation study at purchase, what should you do? According to Wes, it’s not too late.

Using a look-back study (also called a retroactive analysis), you can reclassify assets today and claim depreciation taken in previous years. Also, you don’t have to amend your past tax returns. To “catch up,” Wes advises, you file IRS Form 3115, which uses what’s called an adjustment under 481(a).

For example:

• In 2020, you purchased a property.
• Using straight-line depreciation, you could deduct $20,000 over four years.
• According to a retroactive cost segment study, you could have taken $300,000.
• When you file your next tax return, you take a deduction of $280,000 all at once.

As a result, cost segregation is a powerful tool, even for long-term property owners.

Real Estate Professional Status: Unlocking Full Value

To maximize your income, Wes says that you need to understand the difference between active and passive income. Generally, real estate losses can only be offset against passive income. In contrast, if you qualify as a real estate professional, you can deduct all your income, including your income from a W-2 job.

To qualify, you must:

• Spend at least 750 hours a year on real estate activities.
• Compared to any other profession, you spend more than half your time on real estate activities.

If you materially participate in managing the property, you can still qualify for non-passive losses through other strategies, such as the short-term rental loophole.

The Bottom Line

The cost segregation concept is a game-changer for real estate investors. By using it, you can immediately save on taxes on a large, long-term asset. By accelerating depreciation and taking advantage of bonus depreciation, you can lower your tax bill, increase your cash flow, and build wealth faster.

Whether you’re new to investing or an experienced professional, cost segregation studies can unlock significant value and enable you to retain more of the profits you generate.

Key Takeaways

• Accelerate depreciation. By reclassifying components into shorter-life categories (5, 7, and 15 years) instead of the standard 27.5 or 39 years, cost segregation accelerates the depreciation of a property.
• Generate “paper losses.” You can use these losses to offset your taxable income, reducing your tax liability without incurring any expenses.
• Turbocharged by bonus depreciation. With bonus depreciation, a substantial portion of an asset’s cost can be written off in the first year, supercharging the strategy.
• Specialized properties benefit the most. Car washes and medical offices, which often require numerous improvements and specialized equipment, benefit most from tax savings.
• It’s not too late. Using a retroactive cost segregation study, you can claim all the depreciation that was missed in previous years in one lump sum.
• Offset all income. If you want to utilize these losses fully, you will need to qualify as a real estate professional, which allows you to offset active income (wage income) with passive income.
• A wealth-building strategy. You can build wealth more efficiently and improve cash flow through cost segregation, rather than relying on a simple tax tactic.

Featured Image Credit: The Lazy Artist Gallery; Pexels: Thank you!