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Cost Segregation for Real Estate Investors: What to Know

Real estate investors who hold single-family rentals or multifamily properties know that cash flow is vital. That’s why they look for any efficiency or expense reduction.

One tool that many investors use is cost segregation. This strategy uses the tax benefits of accelerated depreciation. By allowing investors to deduct more expenses sooner rather than later, cost segregation can help investors save dollars and increase their cash flow, especially if they plan to hold properties.

Because cost segregation is a tax strategy, it’s important for investors to consult a qualified tax professional if they are considering using this tool. In this post, we won’t offer tax advice, but we will provide information on what cost segregation is and how it works.

What Is Cost Segregation in Real Estate?

Cost segregation accelerates depreciation by reclassifying some building components into shorter-lived asset categories. This can increase early-year tax deductions for property owners.

What Property Components May Be Eligible for Accelerated Depreciation

Costs that can be segregated in this strategy include components like:

• Flooring
• Fixtures
• Cabinets
• Landscaping
• Lighting Fixtures
• Specialized Electrical Systems

A qualified tax professional who  specializes in cost segregation can analyze specific properties to see what components on that property may qualify.

How Depreciation Works for Investment Properties

Typically, depreciation on a commercial property (which, in this case, is a residential property owned as an investment) works on a standard depreciation schedule of 27.5 years. Depreciation provides a tax write-off that reduces the tax burden on the investment.

Cost segregation isolates certain costs within the property and puts them on an accelerated depreciation schedule, which can provide the investor with more tax write-offs earlier. This reduces the tax burden even more, thus increasing the profit margin and the cash flow for the investor who owns the property.

What Is a Cost Segregation Study?

A cost segregation study is an engineering-based examination of a property to identify building components that are eligible for shorter depreciation schedules. It also includes documentation that a tax professional can use on tax returns.

Lima One Capital has partnered with CSSI, a company that specializes in cost segregation studies for residential investment properties. CSSI provides a free preliminary analysis to investors to help them determine whether a cost segregation study is a good fit for their properties.

When a Cost Segregation Study Can Be Done

A cost segregation study can happen at any point, but it is often most advantageous in the first year or two after an investor purchases, rehabs, or builds a property.

Potential Benefits of Cost Segregation for Real Estate Investors

Cost segregation offers investors the benefits of increased cash flow on their rental properties, as well as recently completed flips or new builds that they plan to hold. Investors who complete cost segregation studies and consult their tax professionals about the results can reap these benefits.

Accelerated Depreciation and Cash Flow

Faster depreciation schedules can lead to more early-year cash flow for investors. Savvy investors can then use this additional profit to grow their portfolios.

When Real Estate Investors Typically Consider Cost Segregation

Investors typically benefit most from cost segregation studies in the first 1-3 years of owning a property, or in the first 1-3 years after  completing rehab or construction on the property.

In addition, investors typically need to own a property for 5-7 total years to maximize the benefits of cost segregation after accounting for the cost of a cost segregation study.

Again, cost segregation works on a case-by-case basis. Getting a free property analysis and consulting a qualified tax professional are essential to understanding the exact timing at which any investment property may be a suitable candidate for cost segregation.

Cost Segregation for Rental Property Investors

Single-family rental investors who hold properties long term are prime candidates to benefit from cost segregation. Because of their investment timeline horizon, they have the time to benefit from tax write-offs to a greater extent. This helps to offset the investment in a cost segregation study.

Cost Segregation for New Construction or Value-Add Projects

Often, investors who renovate or build projects add components to their properties that are ideal candidates for cost segregation. If they plan to hold these properties, investigating cost segregation options may be a way to improve cash flow.

Important Considerations Before Pursuing a Cost Segregation Study

Investors who are considering cost segregation should be aware of the following factors:

• Cost segregation costs. Usually, an investor needs to hold a property for at least 3-5 years to save enough from cost segregation to justify the cost of a cost segregation study.
• Eligibility. Components are not automatically eligible for segregation just because they are present. A strong cost segregation analysis will identify what is eligible and what may not be.
• Tax advice. Because cost segregation is a tax reduction strategy, investors need to consult a qualified tax professional before choosing this strategy.

A free preliminary analysis like the one CSSI offers to Lima One customers is a vital step that can help investors understand whether a cost segregation is a valuable strategy for their portfolio.

Financing Investment Properties with Lima One

Lima One offers financing for different investment strategies that may benefit from cost segregation, including:

• Buy-and-hold rental property and portfolio investment
• Fix and flip and Fix2Rent^® BRRR investing
• New construction investment and Build2Rent^® strategies

Lima One’s financing is another tool that can help investors profit as they scale their real estate businesses.

The Lima One Advantage for Real Estate Investors

Real estate investors need a deep toolbox to maximize profit and cash flow. Cost segregation is one of the tools in that toolbox, but it takes experience and expertise from a tax professional to execute.

As real estate investors continue to build their portfolios, Lima One is ready to provide industry-leading financing designed specifically for scaling investors. Apply for a loan today to see how Lima One financing can help you accomplish your investment goals.