Cost segregation and traditional depreciation are two methods used to allocate and recover the costs of real estate investments over time, but they differ significantly in approach and benefits.
Traditional Depreciation
- Involves depreciating an entire building as a single asset, typically over 27.5 years (residential) or 39 years (commercial) using the straight-line method.
- This method assumes the entire property has a uniform useful life, leading to slower tax deductions over time.
- Commonly used for simplicity and compliance with IRS regulations.
Cost Segregation
- A tax strategy that accelerates depreciation by identifying and reclassifying components of a property into shorter asset lives (e.g., 5, 7, or 15 years).
- Items such as flooring, electrical systems, plumbing, and landscaping may qualify for faster depreciation.
- This method leads to larger deductions in the early years, improving cash flow and reducing taxable income.
Key Differences
| Feature | Traditional Depreciation | Cost Segregation |
|---|---|---|
| Depreciation Timeline | 27.5 or 39 years | 5, 7, 15, 27.5, or 39 years |
| Cash Flow Impact | Slower tax deductions | Larger upfront deductions |
| IRS Compliance | Standard approach | Requires a cost segregation study |
| Complexity | Simple | More complex, requires experts |
When to Use Cost Segregation
- Best for newly purchased, constructed, or renovated commercial or rental properties.
- Particularly beneficial for property owners looking to accelerate deductions and reduce current tax liability.
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