Drastically Decrease Your Tax Liability With Depreciation and Cost Segregation

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The wealthiest people in America tend to have one thing in common—they own real estate! Why? Owning real estate grants the ability to effectively reduce your tax liability. Depreciation and cost segregation are two of the more powerful tax strategies when building wealth through real estate. While earning a higher income comes with higher tax implications, the IRS allows real estate investors to take advantage of these favorable tax deferrals and write-offs when implemented strategically. NOTE: This article is not to be construed as tax advice. Always consult your tax professional.

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What is Depreciation?

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Depreciation is an income tax deduction that measures the decline in the value of an asset over time. Even though the asset may not actually lose its value, the IRS allows you to depreciate the "losses" against the useful life of the property. Why is this significant? Because it reduces your tax liability on the cash flow the property generates, adding power to your ability to create wealth through real estate.

The IRS allows residential real estate (e.g. multifamily) to be straight-line depreciated over 27.5 years, and commercial real estate (e.g. an office building) to be depreciated over 39 years. This means that, for a residential property, you are able to depreciate 1/27.5 of the building's value (excluding the value of the land) against your cash flow income. For example, if you purchased a $1,200,000 property in which $200,000 was allocated to the land improvement, you would be able to deduct $36,363.63 (1/27.5 or 0.036 x $1,000,000) from the income generated by the asset. As always, please consult with your tax professional for an in-depth understanding of depreciation.

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What is Cost Segregation?

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Cost segregation is the process of performing an engineered study to "breakdown" some components of the building into personal property and land improvements. The components are then classified and accelerated from the straight-line basis of 27.5 years to 5, 7, and 15 years. This is an IRS-recognized tool to accelerate your depreciation schedule as a reflection of time value of money. This concept of time value of money simply implicates that "a dollar today is worth more than a dollar tomorrow" and cash now is better than cash tomorrow. These substantial tax savings add to the amount that depreciation can reduce tax liability on your cash flow.

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Summary:

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Please consult your tax professional when using tax strategies. Using depreciation and cost segregation on your real estate investment can drastically increase returns for owners of cash-flowing multifamily real estate. This is one of the many ways millionaires are made from real estate investors.

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Author: Yannik Cudjoe-Virgil, MICP

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Yannik formed Merlynn Acquisitions in 2017. He has experience in portfolio asset management, real estate investing, investment analysis and financial modeling.