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October 16, 2024, BY Paul Tanso
In Part 1, we covered an overview of what cost segregation is, and when and how to use it. cost segregation can supercharge your tax savings—whether you use it right after purchasing a property, after completing major renovations, or even a year or two in to claim missed depreciation. Now, let’s dive deeper into one of those strategies: using cost segregation after major upgrades.
If you’ve invested in significant improvements—like new HVAC systems, a roof replacement, or adding new amenities—cost segregation can work even harder for you. In this section, we’ll break down how you can maximize tax savings after renovations, how different types of upgrades are treated for tax purposes, and why this strategy can make your renovations even more valuable.
Why Does Cost Segregation Exist? (And Who Do We Have to Thank?)
You might be wondering, “Why does cost segregation even exist, and who thought this up?” The answer lies in the tax code. Believe it or not, cost segregation is designed to encourage investment in real estate and boost economic growth. The IRS created depreciation rules to help property owners offset the natural wear and tear on buildings, recognizing that properties lose value over time.
But let’s face it, some parts of a property—like carpets, appliances, and parking lots—wear out much faster than the building itself. The IRS, being surprisingly logical on this one, says, “You don’t have to wait nearly three decades to write off your old dishwasher or crumbling sidewalk.”
So, cost segregation was born. It’s been around for a while, but it gained real momentum with the Tax Reform Act of 1986, which formalized the rules around accelerated depreciation. This was done to help real estate developers and investors keep more cash in their pockets sooner, allowing them to reinvest and build more, effectively stimulating the economy.
And who do we have to thank for this? Well, you could say Ronald Reagan. The Tax Reform Act of 1986, passed during his presidency, introduced several tax incentives aimed at fueling real estate development. Of course, tax attorneys and CPAs have refined the use of cost segregation over the years, making it a mainstream strategy for property owners.
In short, cost segregation exists because the government wants to incentivize investment, encouraging people like you to put your money into real estate and build something meaningful. So, every time you’re reaping the tax benefits of cost segregation, give a little thanks to tax reform, savvy tax professionals, and a system that benefits investors.
Cap-Ex vs. Repairs and Maintenance
When you perform major renovations on your property, it’s important to understand the difference between capital expenditures (Cap-Ex) and repairs and maintenance, as they are treated differently from a tax perspective.
Capital Expenditures (Cap-Ex): These are improvements that increase the property’s value or extend its useful life, such as a new roof, replacing major systems like HVAC, or installing new windows. Cap-Ex expenses must be capitalized and depreciated over time. However, a cost segregation study can accelerate the depreciation of some of these improvements (like carpets or landscaping) to shorter schedules.
Repairs and Maintenance: These are expenses that keep the property in good working condition but don’t necessarily add value or extend its life. Examples include patching a roof or fixing plumbing. These costs are deductible immediately in the year they’re incurred, providing instant tax benefits.
In short: Cap-Ex is depreciated over time, while repairs and maintenance can be written off immediately.
How Renovations Are Treated in a Cost Segregation Study
When you make significant renovations—like replacing carpets, cabinets, siding, or driveways—a real estate cost segregation study will categorize these improvements into the appropriate asset classes, accelerating the depreciation for certain components.
Here’s how it breaks down:
By performing a cost segregation study after renovations, you can allocate shorter depreciation schedules to personal property items like carpets, cabinets, and land improvements like driveways, accelerating your tax savings.
The Benefits of a Cost Segregation Study (aka “Show Me the Money”)
Increased Cash Flow: Accelerating depreciation means you pay less in taxes early on. And less tax equals more cash for you. Think of it like finding extra fries at the bottom of the bag—it’s an unexpected bonus.
Tax Deferral: With cost segregation, you’re pushing some taxes down the road. It’s like telling the IRS, “I’ll deal with you later,” and in the meantime, you’re free to reinvest that cash or buy yourself something shiny (like more property).
Flexibility: If you’re holding a property for 5–10 years, this strategy works great. And if you do a 1031 exchange (which is basically hitting the IRS snooze button), you can push those taxes even further down the line.
Next up: “Maximizing a Cost Segregation Study at the Time of Purchase (and Supercharging it with Bonus Depreciation)”
In Part 3, we’ll explore how to make a cost segregation study work for you right at the time of purchase—and how pairing it with bonus depreciation can help you stack tax benefits and increase cash flow even more. Plus, we’ll discuss some potential risks you should be aware of before diving in.
I’d love to hear your thoughts!
Have you used a cost segregation study in your real estate investments? Do you have any questions or experiences with tax strategies that worked for you? Let me know in the comments—I’m always open to feedback, corrections, or new ideas. Let’s keep the conversation going!
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