Drastically Decrease Your Tax Liability With Depreciation and Cost Segregation

The wealthiest people in America tend to have one thing in common—they own real estate!

Why? Owning real estate grants the ability to effectively reduce your tax liability.

Depreciation and Cost Segregation are two of the most powerful strategies that real estate makes available. While earning a higher income comes with higher tax implications, the IRS allows real estate investors to take advantage of these favorable tax deferrals and write-offs.

Depreciation

Depreciation is an income tax deduction that measures the decline in the value of an asset over time. Even though the asset may not actually lose its value, the IRS allows you to depreciate the "losses" against the useful life of the property. Why is this significant? Because it reduces your tax liability on the cash flow the property generates, adding power to your ability to create wealth through real estate.

The IRS allows residential real estate (e.g. multifamily) to be straight-line depreciated over 27.5 years, and commercial real estate (e.g. an office building) to be depreciated over 39 years.

This means that you are able to depreciate 1/27.5 of the value of a residential investment property (excluding the value of the land) every year against your income from that property.

For example, if you purchased a $1,200,000 property and $200,000 of the purchase price was allocated to the land, you would be able to deduct $36,363.63 (1/27.5 or 0.036 x $1,000,000) from the income generated by the asset. If the income in a given tax year were less than $36,363.63, you'd pay no tax at all on the income from that property for that tax year.

Cost Segregation

Cost segregation is the process of performing an engineering study to "breakdown" some components of the building into personal property. This includes wall coverings, electrical wiring, plumbing fixtures, floor coverings, appliances, walkways, etc. The components are then classified and accelerated from the straight-line basis of 27.5 years to 5, 7, and 15 years. This is an IRS-approved tax deferral strategy to accelerate your depreciation schedule as a reflection of time value of money. This concept of time value of money simply implicates that "a dollar today is worth more than a dollar tomorrow" and cash now is better than cash tomorrow. These substantial tax savings add to the amount that depreciation can reduce tax liability on your cash flow.

Bonus Depreciation

Bonus depreciation is a stimulus measure created under the Job Creation and Worker Assistance Act of 2002. It allows taxpayers to depreciate a certain percentage of the cost of eligible business property during the asset's first year in service. Under this Act, bonus depreciation was only available for new property, and taxpayers could only depreciate up to 50 percent of the property's cost.

Enter the 2017 Tax Cuts and Jobs Act (TCJA). This new law changed the game completely by allowing tax payers to take bonus depreciation on newly acquired, used property. It also allowed taxpayers to depreciate 100 percent of the cost of eligible property during its first year in service through tax year 2022.

Summary

This combination of these tax law changes and deferral strategies create very substantial and immediate deductions for real estate investors and thereby increases their cash flow.

Note - This article should not be interpreted as tax advice. Consult your tax professional before making investment decisions and applying advanced tax strategies like these to ensure compliance with IRS guidelines.