Author, David Armenta
Broker/Lender
How do the rich get rich, and how do they stay rich? Using the tax code, That's how they do it! More importantly, how do they keep their families wealthy and benevolently powerful?
Depreciation and cost segregation are powerful tools in tax planning, especially for real estate investors and business owners. Here's how they work to lower your adjusted gross income (AGI) and your overall tax obligation:
Depreciation
Depreciation is a method of allocating the cost of a tangible asset over its useful life. The IRS allows you to deduct a portion of the cost of an asset each year as an expense. Here's how it helps:
- Reduces Taxable Income: Depreciation is a non-cash expense, meaning you can deduct it from your taxable income without an actual outflow of cash. This lowers your AGI.
- Lowers Tax Obligation: By reducing your AGI, depreciation reduces the amount of income subject to taxation, thereby lowering your tax obligation.
- Different Methods: The IRS allows different methods of depreciation, such as the straight-line method or the accelerated method (e.g., MACRS - Modified Accelerated Cost Recovery System). Accelerated methods allow larger deductions in the earlier years of an asset’s life.
Cost Segregation
Cost segregation is a tax strategy that identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes. Instead of depreciating an entire building over 27.5 years (residential) or 39 years (commercial), you break down the building into components that can be depreciated over shorter periods (e.g., 5, 7, or 15 years).
- Accelerates Depreciation: By accelerating depreciation, cost segregation allows you to front-load depreciation expenses, resulting in larger deductions in the early years of property ownership.
- Enhances Cash Flow: Larger depreciation deductions reduce taxable income more significantly in the earlier years, enhancing cash flow by reducing the tax burden.
- Capitalization of Certain Costs: Certain components, such as fixtures, flooring, and landscaping, can be depreciated over shorter periods, leading to quicker tax benefits.
Impact on Taxes
- Lowering AGI: Both depreciation and cost segregation reduce your AGI by increasing deductible expenses. This can also potentially qualify you for other tax benefits tied to lower AGI thresholds.
- Tax Deferral: These strategies don't necessarily eliminate taxes but defer them. You reduce your current tax obligation, freeing up capital for investment or other uses.
- Potential Zero Tax Liability: In some cases, especially for high-value properties or significant business assets, the deductions from depreciation and cost segregation can be substantial enough to offset all taxable income, potentially resulting in zero tax liability for that year.
Example
Imagine you purchase a commercial property for $1,000,000. Using cost segregation, you identify $300,000 worth of assets that can be depreciated over 5 years instead of 39 years.
- Without Cost Segregation: You might have an annual straight-line depreciation of around $25,641 ($1,000,000 / 39 years).
- With Cost Segregation: You might front-load $60,000 ($300,000 / 5 years) for the first 5 years, plus the depreciation on the remaining $700,000 over 39 years, significantly increasing your deductions in the early years.
Conclusion
Depreciation and cost segregation are used to lower AGI by increasing deductible expenses, thereby reducing your taxable income and overall tax obligation. While they can significantly lower or even eliminate tax liability in some years, they primarily defer taxes to future years rather than eliminating them permanently. Proper planning and execution are essential, often requiring the assistance of tax professionals or cost segregation specialists.
