When it comes to maximizing tax benefits in real estate, few strategies are as effective as bonus depreciation and cost segregation analysis. These advanced tax planning tools allow investors to unlock substantial tax savings by accelerating depreciation deductions. Here’s a closer look at how these strategies work and their impact on passive real estate investing.
Cost Segregation Analysis: Breaking Down Property Components
A cost segregation analysis is an IRS-approved method of identifying and reclassifying components of a real estate property into shorter-lived categories. Instead of depreciating an entire property over the traditional 27.5 or 39 years, cost segregation allocates portions of the property to shorter depreciation schedules, such as 5, 7, or 15 years.
How It Works
Cost segregation focuses on separating the components of a property into categories such as:
- Land improvements (e.g., landscaping, parking lots): 15-year depreciation schedule.
- Building systems (e.g., HVAC, electrical, plumbing): 5 to 7-year schedules.
- Personal property (e.g., carpeting, appliances, fixtures): 5 to 7-year schedules.
By reclassifying these components, investors can accelerate their depreciation deductions in the early years of ownership, boosting cash flow and reducing taxable income.
The Benefits
Accelerated Deductions: Front-loading depreciation allows investors to recover more of their investment sooner, enhancing the time value of money.
Increased Cash Flow: By lowering taxable income in the early years, cost segregation improves after-tax cash flow.
Customizable Analysis: A cost segregation study is tailored to the property, ensuring precise allocation and compliance with IRS regulations.
Bonus Depreciation: Supercharging Cost Segregation
Bonus depreciation complements cost segregation by allowing investors to immediately deduct a large portion of the value of certain property components in the first year of ownership.
How It Works
- The Tax Cuts and Jobs Act (TCJA) of 2017 expanded bonus depreciation to include 100% of qualifying property acquired and placed in service after September 27, 2017. (As of 2023, this percentage began phasing down, but it still offers significant benefits.)
- Bonus depreciation applies to property with a useful life of 20 years or less. This includes the reclassified assets identified in a cost segregation study, such as carpeting, appliances, and landscaping.
The Benefits
Immediate Tax Savings: Investors can deduct 100% (phased down in increments) of qualifying assets’ costs in the first year, creating substantial tax deferral opportunities.
Enhanced ROI: By reducing tax liabilities early, bonus depreciation increases the effective return on investment.
Scalable Application: Bonus depreciation is applicable across a wide range of properties, from residential rentals to large-scale commercial buildings.
An Illustrative Example: Cost Segregation + Bonus Depreciation
Let’s consider a real estate syndication that acquires a $10 million apartment building.
Traditional Depreciation Schedule:
Without cost segregation, the building depreciates over 27.5 years, yielding annual deductions of approximately $363,636.
Cost Segregation Analysis:
A study identifies $2 million in assets that qualify for 5- and 7-year schedules (e.g., appliances, fixtures, and carpeting).
Another $1 million in landscaping qualifies for a 15-year schedule.
Bonus Depreciation Impact:
The $3 million in reclassified assets qualifies for immediate deduction under bonus depreciation (subject to phase-out percentages).
In the first year, the syndication deducts the $3 million, in addition to the standard depreciation on the remaining $7 million, resulting in a significant tax shield.
Key Takeaways
Cost segregation is most effective for properties with high construction or acquisition costs that feature a mix of structural and non-structural assets. To ensure the study meets IRS requirements, a qualified cost segregation professional is essential. It’s also important to note that bonus depreciation is being phased down, starting at 100% in 2023, dropping to 80% in 2024, and continuing to decrease, so acting promptly is key to maximizing benefits. While reinstating the Tax Cuts and Jobs Act (TCJA) would require an act of Congress and the President’s signature, with the House, Senate, and presidency under Republican control heading into 2025, there’s expected momentum for its renewal. Additionally, depreciation deductions may be limited by passive activity loss rules unless the investor qualifies as a real estate professional or offsets other passive income.
Conclusion
By combining cost segregation analysis with bonus depreciation, real estate investors can dramatically accelerate tax savings, improve cash flow, and maximize investment returns. These tools are particularly advantageous for passive real estate investors, as they provide immediate financial benefits without requiring hands-on management. With proper planning and professional guidance, these strategies can transform real estate investments into highly tax-efficient wealth-building vehicles.
Ready to explore passive real estate opportunities? Learn how a diversified multifamily portfolio can become part of your passive investing strategy. Schedule a time to meet with David here.
About the Author
David McKinney is the Managing Director and EVP of Investor Relations at Wilkinson, where he leads the strategic development of real estate funds. With over $2.5 billion in transactions completed during his tenure, David leverages his strategic insights and emotional intelligence to enhance client and team experiences. Beyond his professional endeavors, he is a husband and father, enjoying outdoor adventures in lakes and mountains near his home in Washington State, and he is actively involved in his community as a Rotarian, committee chair advisory board member reflecting his commitment to leadership and service.
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