Depreciation is a tax deduction that allows real estate investors to recover the cost of their investment over a period of time. The idea behind depreciation is that buildings and other real estate assets that have a lifespan such as roofs, siding, flooring, appliances and windows just to name a few examples, will lose value over time due to wear and tear, obsolescence, and other factors.
The IRS allows investors to take a depreciation deduction each year for the expected decrease in value of their property. The depreciation deduction is based on the cost of the property, which includes not only the purchase price, but also the cost of any improvements or renovations made to the property.
The amount of depreciation that can be deducted each year is determined by the property’s useful life, which is set by the IRS based on the type of property. For residential rental properties, the useful life is 27.5 years, while for commercial properties, it is 39 years.
To calculate the annual depreciation deduction, the cost of the property is divided by the useful life. For example, if a rental property was purchased for $500,000, the annual depreciation deduction would be approximately $18,182 ($500,000 divided by 27.5 years).
It’s important to note that depreciation deductions can only be taken on the building and other structures on the property, not on the land itself. The land is considered to have an indefinite useful life and does not lose value over time.
Depreciation is a non-cash expense, which means that it does not require any actual expenditure of cash. However, it can still provide a significant tax benefit for real estate investors by reducing their taxable income and increasing their cash flow.
Cost segregation is a tax planning strategy used by real estate investors to accelerate depreciation deductions, reduce taxable income, and increase cash flow. It involves identifying and reclassifying certain assets within a building or property into shorter depreciation periods for tax purposes.
To calculate the cost segregation for a real estate property, a cost segregation study is typically conducted by a qualified engineer or specialist. The study involves a detailed analysis of the building or property, including its components, systems, and assets. The goal is to identify assets that can be reclassified into shorter depreciation periods.
The cost segregation study will typically involve the following steps:
- Site Inspection: The engineer or specialist will inspect the property to identify assets that can be reclassified.
- Asset Identification: The engineer will identify and list all the assets in the building or property.
- Asset Classification: The engineer will classify the assets based on their useful life and depreciation period.
- Cost Allocation: The engineer will allocate the total cost of the property to the different assets based on their value and useful life.
- Tax Reporting: The engineer will provide a report that outlines the reclassified assets and their new depreciation periods.
Once the cost segregation study is completed, the reclassified assets can be depreciated over shorter periods, resulting in higher depreciation deductions and lower taxable income. This can provide significant tax savings and improve cash flow to real estate investors.