For real estate investors and commercial property owners, understanding how to maximize depreciation can be the difference between a marginal investment and one that delivers outsized returns. Three tax strategies stand out in this space:
- Cost segregation,
- Accelerated depreciation,
- Bonus depreciation
When used together, they can significantly reduce taxable income and increase cash flow, especially in the early years of property ownership.
Let’s break down what each means, how they work together, and why they’re particularly valuable in the current tax climate.
What is Cost Segregation?
Cost segregation is a strategic tax planning tool that allows property owners to reclassify certain components of a building from standard 39-year (commercial) or 27.5-year (residential) depreciation schedules to shorter-lived asset classes (such as 5, 7, or 15 years). These components can include things like carpeting, lighting, HVAC systems, cabinets, landscaping, and even certain electrical or plumbing systems.
By accelerating the depreciation of these components, cost segregation can significantly increase deductions in the early years of ownership—resulting in substantial tax savings.
How Accelerated Depreciation Works
Accelerated depreciation refers to methods of depreciating assets more quickly than the traditional straight-line method. In the context of real estate, this usually applies to assets identified during a cost segregation study. Instead of spreading deductions evenly over 27.5 or 39 years, accelerated depreciation allows for larger deductions in the earlier years of the asset’s life.
This front-loading of deductions lowers taxable income in the short term, improving cash flow.
Bonus Depreciation: Supercharging Cost Segregation
Bonus depreciation allows you to deduct a significant percentage (formerly 100%, and now phasing down — 80% in 2023 and 60% in 2024) of the cost of qualified property in the year it’s placed in service. When paired with cost segregation, this means that all those components reclassified into 5, 7, or 15-year asset lives can be deducted immediately.
For example, imagine you buy a commercial building for $2 million. A cost segregation study determines that $500,000 worth of assets can be moved into short-lived categories. With bonus depreciation still in play, you could deduct up to $300,000 of that in the first year (if using 60% bonus depreciation in 2024). That’s a huge tax break that wouldn’t be available under traditional depreciation rules.
Key Benefits for Real Estate Investors
- Increased Cash Flow: Lower tax bills in the early years of ownership mean more available cash for improvements, debt reduction, or new investments.
- Offset Passive Income: For those with other rental properties or real estate holdings, these deductions can help offset passive income, reducing overall tax liability.
- Short-Term Holdings Advantage: Even if you don’t plan to hold a property long-term, these front-loaded deductions can maximize ROI before a future sale.
- Immediate ROI on Renovations: If you’ve made significant improvements after purchase, those can often be segregated and depreciated separately.
Considerations and Caveats
- Cost Segregation Study: To take advantage of these strategies, you’ll need a formal cost segregation study performed by a qualified engineer or tax advisor. This does come at a cost, but the potential savings often far outweigh the expense.
- Recapture on Sale: When you sell a property, depreciation deductions are subject to recapture and taxed at a higher rate. That said, with good planning, many investors defer or minimize recapture through 1031 exchanges or careful timing.
- Bonus Depreciation Phase-Out: The 100% bonus depreciation rate under the Tax Cuts and Jobs Act is phasing out. In 2024, it’s 60%, and it will continue to decline unless Congress renews or modifies it. This makes it even more urgent to act while the benefit is still sizable.
If you own or are planning to acquire income-generating real estate, cost segregation combined with accelerated and bonus depreciation offers powerful tools to enhance your after-tax returns. While the strategies themselves are sophisticated, the end result is simple: more money in your pocket, sooner.
For property owners in Washington State — especially those in rapidly appreciating markets like Seattle, Bellevue, and Tacoma — these strategies can help manage growing tax burdens while still capitalizing on high-value real estate.
If you’re considering a new acquisition, renovation, or simply want to ensure you’re not leaving money on the table, get in touch with our team to explore your options.