In terms of asset management and tax strategy, property owners and investors are always looking for legal ways to improve cash flow and yield rates. One potent but underutilized engineering-based study is likely to deliver these benefits-it’s called cost segregation analysis, a process that fundamentally alters the financial profile of a property by accelerating depreciation deductions. For commercial and residential rental property owners, understanding this tool is fundamental not to mere accounting practices but to more strategic financial maneuvers.
How Does Property Depreciation Work Generally?
When you buy a building, there is a long “useful life” during which time, according to the Internal Revenue Service, you may deduct the cost for the wear and tear on the building. The recovery period for commercial property is normally 39 years while for residential rental property is 27.5 years. As a result, you cannot deduct very much of that cost every year-a bit more than 2.56% for commercial and 3.636% for residential buildings. This method gives a uniform treatment of the entire structure, but is this a true reflection of the reality of that asset?
What if the elements that complete your building have a significantly shorter lifespan than the building itself? Think of the carpeting or specialized lights, or plumbing fixtures. Do they last that long? The basic premise of a specialized engineering study challenges this conventional depreciation model which compartments the property into its individual parts.
What Parts of a Building Can Be Recharacterized?
The detailed study is carried out by qualified professionals to break the total purchase price or construction cost of a property into its constituent parts. This is not a superficial review, either; it is a deep dive through architectural drawings, construction invoices, and the physical asset itself. The whole scope is to identify all the assets that can be classified with a shorter recovery period.
So, what sorts of things are found by such asset identification? Generally, three main categories include:
Personal Property: Personal property generally includes any items that fall outside of the structural definition of the building and can be defined in some way. Examples would include furniture, fixtures, and equipment (FF&E)-think movable partitions; decorative lighting; window treatments; or office furniture.
Land Improvements: These are improvements to the land but have a relatively short life, apart from the building. This includes the construction of parking lots, sidewalks, fences, and exterior landscaping lighting.
Certain Building Components: Maybe the least expected of all the categories, this includes certain components of the building’s structure which are believed to have a valid life shorter than that of the building itself. This may be specific electrical wiring dedicated to certain equipment, plumbing for certain uses, and even some types of wall finishes.
The study then provides for switching these items from 39 or 27.5 years to 5, 7, or 15-year property. By doing this, the study actually creates a very substantial front-loaded depreciation deduction.
What Are Real Benefits?
The main benefit of this strategy is a dramatic improvement in near-term cash flow. By “front loading” depreciation deductions, a property owner brings down significantly his or her taxable income for the first few years in ownership, creating temporary tax deferral-interest-free loans from the government. The money can be reinvested in the business, into property improvements or into repayment of debts.
But is it just a momentary advantage? In later years depreciation deductions will be lower, but this is where the principle of time value comes into play and makes it an excellent trade-off. One dollar saved in taxes today is worth more than saving a dollar in ten years from now. Additionally, the fresh property acquisition can attract the most benefits from this scheme during a renovation period or a year when, because much income is made, the owner is in the highest tax bracket.
Can all Properties Use This Method?
While the benefits of this strategic undertaking sound great, the inheritance of these benefits varies from property to property, and indeed the entire effort is not implemented in a cookie-cutter model. Realistically, several factors should be considered. What was the acquisition cost or budget for construction? In principle, higher-cost properties generally yield greater benefits. What is the owner’s tax position at present? It benefits most considerably those high-salary earners. The type, age, and specific use of the property, too, are key in determining the outcome. A thorough evaluation of cost-benefit analysis needs to be done with a tax advisor and a qualified professional to find out whether projected benefits outweigh the costs of study initiation. For the right owner and right property, however, this tool remains undoubtedly one of the most powerful one’s in proactive tax planning and wealth accumulation.
