To truly unlock the tax-saving potentials of real estate investments, LP investors can take advantage of bonus depreciation and cost segregation. These two strategies work hand-in-hand to provide substantial tax benefits in the early years of property ownership, allowing investors to accelerate deductions and significantly reduce taxable income.
What is Bonus Depreciation?
Bonus depreciation allows investors to take an immediate deduction for a significant portion of the cost of qualifying assets in the first year they are placed into service, rather than spreading the depreciation over the asset’s useful life. Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, investors could only depreciate 50% of certain assets. However, the TCJA expanded this benefit, allowing 100% bonus depreciation on qualifying property, which applies to both new and used assets.
This means that in the year the asset is placed into service, the investor can deduct its full value upfront, effectively accelerating the tax benefit. For real estate investors, this includes items such as equipment, fixtures, or improvements to the property.
In the recent Lunch and Learn – Maximizing Tax Efficiency in LP Investments with Brandon Hall, CPA – hosted by Tempo Family of Funda & Syndications, Brandon Hall explains, “If we then add the concept of bonus depreciation to this, now I’ve got the same revenue and expenses so my net operating income is still 10,000 but now I’ve got $60,000 of depreciation expense so now I’m telling the IRS that I lost $50,000.” In this example, the investor’s taxable income appears negative due to the depreciation expense, even though the property may be generating positive cash flow. This creates a powerful tax-saving mechanism, enabling investors to reduce or even eliminate taxes on their rental income.
What is Cost Segregation?
Cost segregation is a tax strategy that allows real estate investors to break down their property into different components and depreciate certain parts at an accelerated rate. Instead of depreciating the entire building over 27.5 years (for residential properties) or 39 years (for commercial properties), cost segregation enables investors to identify components within the property that have a shorter depreciation period, such as fixtures, landscaping, or certain building improvements. These components can then be depreciated over 5, 7, or 15 years.
A cost segregation study is typically conducted by a tax professional or engineer who analyzes the property and allocates costs to various categories. This reclassification can make a significant portion of the property eligible for faster depreciation. When combined with bonus depreciation, it results in immediate and substantial tax savings. For high-income earners looking to offset passive income or future capital gains, upfront depreciation is especially valuable as it can create paper losses.
How Bonus Depreciation and Cost Segregation Work Together
When used together, cost segregation and bonus depreciation can create a powerful tax-deferral tool. By performing a cost segregation study, you identify the assets within the property that qualify for accelerated depreciation. These assets are then depreciated more quickly, often over 5 to 15 years. Additionally, under the bonus depreciation rules, you can deduct 100% of these shorter-lived assets in the year they are placed into service.
For LP investors in real estate syndications, this means receiving large depreciation deductions early in the life of the investment, even if the property is producing strong cash flow. These paper losses can offset passive income from other real estate investments or be carried forward to offset future income or capital gains. Even if the investor doesn’t immediately benefit from these losses, they can be deferred and applied when the property is eventually sold, significantly reducing the tax hit from capital gains.
Real-World Example of Cost Segregation and Bonus Depreciation
To better understand the impact of these strategies, let’s look at a simplified example:
Suppose you invest in a commercial property through an LP syndication. The property is purchased for $1 million, and a cost segregation study is performed, identifying $300,000 worth of assets that qualify for shorter-term depreciation (such as equipment, fixtures, and improvements). Under the bonus depreciation rules, you can deduct the full $300,000 in the first year the property is placed into service.
If your share of the property’s passive income for the year is $50,000, the $300,000 deduction would more than offset this income, potentially resulting in a paper loss of $250,000. This loss can be used to offset other passive income or carried forward to offset future income or capital gains.
Why This Matters for LP Investors
Cost segregation and bonus depreciation are especially valuable for LP investors in real estate syndications, as these tax strategies provide a way to accelerate tax savings early in the investment period. This is particularly useful for high-income earners or those with significant passive income from other real estate investments. The ability to generate large paper losses upfront reduces taxable income and increases cash flow, allowing investors to reinvest their savings into additional real estate ventures.
These strategies are also crucial for investors focused on long-term wealth building. By reducing taxable income now and deferring taxes into the future, investors can maximize the time value of money — keeping more of their capital working for them in the present while delaying tax payments.
Conclusion
By using cost segregation and bonus depreciation together, LP investors can accelerate their tax savings, reduce taxable income, and reinvest their tax savings back into their portfolios. As with any sophisticated tax strategy, it is essential to work with a knowledgeable CPA who understands real estate and the unique benefits these strategies can provide.
With the right approach, LP investors can not only grow their real estate portfolio but also ensure they are maximizing their tax efficiency at every step.
