Cost Segregation Accelerates Real Estate Depreciation and Tax Savings

Key Quotes

"What usually happens with folks is they buy a property, typically because they don't want to be thinking about the pain of tax and all of that. They just, they're happy, they closed the deal, and they put off any of the details until later. Then they slam everything over to their accountant at year-end or on March 10th, and it goes over to the accountant, and then the accountant just slaps on 27 and a half or 39-year depreciation because that's all the time the accountant has to do. They don't think about anything else, and they just put it in place."

Jeff Hyatt explains that many property owners defer tax considerations until year-end, leading accountants to apply standard, longer depreciation schedules. Hyatt highlights that this common practice overlooks opportunities for accelerated depreciation. This demonstrates a missed chance for tax optimization due to a reactive approach to financial planning.

"So what most people, 70% of the people out there, end up with this 27 and a half or 39-year depreciation, and it doesn't have to be that way. In other words, when you buy a building and you pay a million dollars for it, you have to depreciate it over 27 and a half or 39 years. The IRS will allow you to carve out pieces of the building and move them into a faster life so that instead of waiting 27 and a half or 39 years to write off the building, they can do it more quickly."

Hyatt points out that a significant majority of property owners use standard depreciation schedules, which is not the only option. He clarifies that the IRS permits segmenting building components for accelerated depreciation. This illustrates how a cost segregation study can unlock faster tax write-offs than conventional methods.

"So between the two, you're able to move somewhere between 15% and 25% into a faster life. What does that mean? That means somewhere between, well, call it $100,000 of the purchase price can be accelerated into the faster life, and Brandon, you would get to take an immediate deduction of $100,000 from that."

Hyatt uses a hypothetical $500,000 building purchase to illustrate the financial impact of cost segregation. He explains that 15-25% of the building's value, approximately $100,000 in this example, can be moved into faster depreciation categories. This shows how a portion of the purchase price can become an immediate tax deduction.

"So, we've been doing cost segregation studies since 1996. I joined the firm in '99. From '96 when we started to 2017, we did about 15,000 studies in that span of, call it 20 years. So, we did a lot of studies, and bonus depreciation never ever applied to existing buildings. Bonus came in in '01 after 9/11 as an incentive for new construction because the economy had tanked, and there was no construction going on, and they said, Congress said, 'Hey, let's throw some gas on the fire, let's give bonus depreciation for new construction.'"

Jeff Hyatt details the history of bonus depreciation, noting its initial application solely to new construction after 9/11. Hyatt explains that this incentive was designed to stimulate the economy by encouraging new building projects. This provides context on how tax laws evolve to address economic conditions.

"So, if they're a real estate professional, they spend 750 hours a year doing real estate related stuff, which is negotiating, looking for deals, putting deals, making stuff happen, managing the property for 750 hours or more, and 50% of their time is spent doing that, then they're going to be very close to being a real estate professional. If they're a real estate professional, not only would the losses go to offset income from the apartments, any excess loss would spill over and wipe out their day job income tax."

Hyatt clarifies the requirements for qualifying as a real estate professional for tax purposes. He specifies the need to dedicate at least 750 hours annually and have this constitute over 50% of one's total work time. Hyatt explains that this designation allows losses from rental properties to offset other forms of income, including a primary job.

"So, the problem is when somebody buys a building and they immediately bulldoze it, whatever the land building allocation might have been, so that going back to our $600,000 purchase, $100,000 for land, $500,000 for the building. If the next day after you buy it, you bring in the bulldozer, that whole $600,000 becomes land. It's non-depreciable because you effectively bought that building for the land, and you didn't need the building, didn't want it, you just got rid of it."

Jeff Hyatt describes a scenario where a purchased building is immediately demolished. Hyatt explains that in such cases, the entire purchase price is reclassified as land, which is non-depreciable. This illustrates how the timing of demolition relative to acquisition can significantly impact tax treatment.