Real Estate Depreciation and Cost Segregation: When Tax Benefits Make a Deal Better

A tax deduction can make a property look better on paper than it performs in real life. Real estate depreciation is one of the most valuable tax advantages rental property owners have, but it works best when the deal underneath it already makes sense.

During a recent episode of Your CPA’s Take on Real Estate, Kyle Paxton shared valuable insights on how investors should weigh tax benefits when buying property. The discussion highlighted the importance of putting the economics of a deal first and treating depreciation as a way to improve a strong investment, not a reason to overpay.

Don’t Pay an Extra Dollar Just to Deduct It

One of the most common mistakes is spending more on a property because the extra cost is deductible. The math rarely works in that direction. “If that extra dollar is a 30-40 cent savings in tax, you got to make sure the economics of the thing work,” Paxton said.

A deduction cuts your tax bill by a fraction of what you spent. It doesn’t hand the whole dollar back. Taxes should support a good investment and “not be used to justify a bad investment or just pad the numbers to get the tax benefit.”

When a Higher-Priced Property Can Be the Better Buy

That doesn’t mean the cheaper property always wins. A higher-priced property can be the better investment when the overall economics are stronger. New construction is a good example, and a few factors can justify paying more:

• Better financing, whether through the builder or elsewhere
• Lower expected maintenance in the first several years
• Stronger rents
• A greater depreciable basis, which means more cost recovery through depreciation if the property meets the criteria

How Cost Segregation Speeds Up Depreciation

Depreciation is one of the biggest tax advantages of owning rental real estate, and the reason comes down to timing. “So much of the real estate game, from a tax perspective, is a time value of money,” Paxton explained.

Investors are incentivized to accelerate deductions. The sooner you take them, the sooner you free up cash to put into the next investment and keep the snowball rolling.

Breaking the Building Into Smaller Pieces

By default, the cost of a nonresidential building is recovered over 39 years. A cost segregation study breaks the property into smaller components, and some of those pieces may be deductible in year one.

Depending on the property, that can be 30% to 40% of the building’s basis deducted in the first year. That can significantly reduce year one taxes and free up cash for the next deal.

Watch for Recapture on the Back End

Accelerated depreciation is a timing difference, not a permanent savings. If you take the deductions now and later sell without a strategy in place to address it, “you get hit with the recapture on the back end and pay additional tax.”

That’s why the exit plan belongs in the analysis from day one, not the year you decide to sell.

Let the Deal Carry the Tax Strategy

It all comes down to order of operations. Start with rent, financing, operating costs and capital expenditures. Then look at how depreciation and cost segregation can make a sound investment even better. If the deal only works because of the tax benefit, it probably doesn’t work.

Watch the full episode of Your CPA’s Take on Real Estate to hear Kyle’s take on new construction, after-tax returns and where he would put $500,000 today.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.