Cost Segregation
"Cost Segregation" deals with the depreciation of real estate. The main function of cost segregation is to increase the amount of depreciable write-offs an investor can take every year. The greater the amount of write-offs, the greater amount of money an investor puts (or keeps) in his or her pocket. So by simple definition, cost segregation is a way for investors to get more money out of a deal.
Depreciation as a whole: Many investors get confused over the idea of depreciating real property; mainly because real property increases in value. Real property however is depreciable. Structures such as houses, buildings, etc., do deteriorate over time; as such, investors can write off a percentage of the structure's value every year. (Note: you can only depreciate the value of the structure and not the value of the raw land underneath it.) The amount an investor can write off is based on IRS established "amortization" periods. For residential real estate, the amortization period is 27.5 years. So by taking the price and dividing by 27.5, the investor will calculate the annual write-off. (If a house is worth $275,000.00, then an investor can write off $10,000.00 every year -- $275,000.00 ÷ 27.5 = $10,000.00.) For commercial property, the amortization period is 39 years – so you divide the structure’s value by 39.
Cost Segregation: Cost segregation increases an investor's write-offs by reclassifying amortization periods for the different items that make up the real property. Most investors understand the "state law" mentality that all items affixed to real property become part and parcel of that real property as well. So when you buy a rental home for example, the carpet, the cabinets, the fixtures, the lights and doorknobs, ect., all are deemed as part of the "real property" when you purchase the home. From an IRS standpoint, this is not necessarily true; all of these items standing alone would be considered non-real property and thus qualify for a 5-year, 7-year, or 15-year amortization period instead of the standard 27.5 or 39 year periods. "Cost Segregation" is the idea that for tax purposes (which is governed by federal law), you can reclassify these components as being "non real property" items, and thus take a greater amount of depreciation on them every year.
Cost Segregation – Plugging In Some Numbers: Suppose an investor purchased a commercial structure worth $1,000,000.00. Under normal depreciation, the investor would write off $25,641.00 per year ($1,000,000.00 ÷ 39). If however, a cost segregation study was performed, and 20% of the structure’s components were reclassified as being "non-real" property, then the investor would have an additional $18,051.00 in write-offs. $100,000.00 of the structure could be depreciated on a 5-year period ($40,000.00 a year) while the remaining $400,000.00 would be depreciated at the 39-year period ($20,513.00 a year). So by using cost segregation, the investor would increase their tax write-offs from $12,205.00 a year to $60,513.00. if the investor is in a 28% tax bracket, this restructuring of the depreciation just earned them an extra net amount of $10,108.00 a year – more than doubling their write-offs. (Note: for many investors with multiple properties, the increased depreciation will often lower their entire tax basis, thus lowering the tax obligation owed on all sources of income for the year.
Cost Segregation – More Than Just a Little Money in Your Pocket: A secondary benefit of cost segregation is the freedom it can give an investor. For many investors, property acquisitions have to include both appreciation and income. By using cost segregation, an investor can easily supplement their income, thus, in many cases, they can increase their financing and purchase a greater amount of real estate (which again generates more write-offs and allows them to purchase even more). So cost segregation is more than just a little annual stipend for an investor . . . when included as part of an overall investment strategy, cost segregation can dramatically increase the overall growth rate of an investor’s portfolio.
Is Cost Segregation Hard To Do? Yes and No: Although the basic concept of cost segregation is simple, and the tax calculations are straight forward, the mechanics of a cost segregation is extremely difficult. The IRS has strict regulations concerning cost segregation. First and foremost, a segregation study has to be performed on the property by qualified professionals. This study is to include both engineering and accounting studies; it also includes all developmental cost, designs and many other matters. A full cost segregation study can cost well over a $50,000.00 (and many times over $200,000.00). So as a whole, segregation studies are typically never done on residential properties and/or small commercial property . . . the costs become too great to be beneficial.
So What's the Down Side: Because there is no cost to the actual investor, there is no down-side. However, there are some factors that can nullify some of the benefits of cost segregation. First is the holding period. Because cost segregation simply "front-loads" the tax benefits of a property — allowing the investor to take more depreciation up front, — holding the property for more years than the amortization period will weaken the advantage. (Which is why it is important to constantly move your money forward and acquire more property. A second nullification is "recapture". When a property actually sells for an increased price, the government will make an investor pay back the amount of depreciation that they wrote off on their taxes (set at 25%). However, by doing a 1031 exchange, an investor can avoid having to pay back this recapture in most cases. (Read the paragraph below for more info on 1031s and cost segregation). However, even if the investor ultimately has to re-pay the money that was earned via the tax benefits, all is not a loss. Providing the investor took proper advantage of accelerated depreciation, and acquired more property, they are still in a better overall position. This is the idea of the "time value of money" which many investor under appreciate.
Cost Segregation and FDC Services Group: Cost segregation is just one more layer of investment strategy that FDC Services Group brings to the table with their opportunities. Whereas the average investor would never afford a cost segregation (or even know of one), FDC Services makes them available with all amenable properties. Furthermore, because of the strategic planning of FDC Services, the FDC Group will constantly have future investment s that will help investors move their money forward and continue with greater depreciation benefits. By using the strength of numbers with their growing investor base, FDC is able to negotiate cost segregations studies to be performed on all properties at the developer's cost. It is just one more reason why investing with FDC Services can be more profitable than investing on one's own.
Cost Segregation and 1031 Exchanges take advantage of a perfect loophole in the IRS tax code. Under section 1031 of the IRS tax code – which allows investors to defer both capital gains and depreciation recapture – state law determines the definition of real estate. As such, all components of a property, including segregated items, are again considered as being real estate. This means the accelerated depreciation taken on these items can also be deferred from annual tax returns. Replacement properties must allow for similar segregation; FDC Services will always have streams of opportunities to help satisfy this requirement. When combining cost segregation with 1031 exchanges, investors can move their money forward at a far greater pace. To understand more about this connection, and how it can accelerate the growth of your net worth, click below to read our section on 1031 exchanges.
Learn More About 1031 Exchanges