Are you a real estate investor in California looking to add value to your residential income property by adding an Accessory Dwelling Unit (ADU)? Cost segregation might be the tax strategy you need.
At Adapt Dwellings, we’re Bay Area leaders in ADU planning, and our experience can help you take full advantage of your new ADU with tax optimization strategies.
In this article, we’ll explore the ins and outs of cost segregation for ADUs and show you how to speed up your property’s allowed Federal Tax Depreciation to gain significant tax benefits and improve your after-tax cash flow.
What is Depreciation?
In investment real estate, depreciation accounts for wear and tear over time. Just as a car wears out over the years, so, too does the building improvements of your rental property, or in this case, an ADU. The IRS naturally assumes rental property improvements will wear out and gives an automatic depreciation schedule of 27.5 years for residential rental properties and 39 years for commercial properties. That depreciation can be subtracted from your taxable income yearly, reducing your tax liability.
What is Cost Segregation?
Cost segregation is a tax planning tool that allows property owners to accelerate depreciation deductions on specific components of their real estate investments. By reclassifying assets into different depreciation categories, like the roof, cabinets, or other appliances, cost segregation can help reduce tax liability and increase after-tax cash flow.
Why is Cost Segregation Relevant for ADUs?
As the demand for affordable housing grows in California, the state has made it easier for real estate investors to build ADUs on their multi-family properties. In recent years, ADUs have become a popular way to add housing units in single-family neighborhoods and increase the density of multi-family properties. However, the costs associated with constructing an ADU can be high, with average total costs ranging from $146,500 to $216,500 for a new construction ADU and $111,750 to $158,750 for a garage conversion ADU.
With the rising costs of construction materials, labor and rising interest rates, cost segregation can help offset some of these challenges by reducing taxes on the property’s after-tax cash flow. By accelerating depreciation on specific components of the ADU, property owners can lower their taxable income and potentially save thousands of dollars in the process. In addition, real estate investors may use depreciation to offset their total ordinary income.
How Does Cost Segregation Work for ADUs?
Cost segregation for ADUs involves identifying and reclassifying the various components of the building into different asset categories, such as 5-year and 15-year property. These shorter-lived assets are depreciated at an accelerated rate, allowing property owners to claim larger depreciation deductions in the early years of ownership.
To perform a cost segregation study, tax and engineering experts will analyze the construction documents, blueprints, and other relevant information to determine the appropriate asset classifications. The cost of a study can vary depending on the size and type of the property,
Benefits of Cost Segregation for ADUs
- Increased after-tax cash flow: By accelerating depreciation deductions, cost segregation can help property owners reduce their tax liability and increase their after-tax cash flow in the early years of ownership.
- Tax savings: The amount of tax savings will depend on the depreciable basis of the improvements, property type, and the amount of short-life assets the property has. In many cases, the benefits of cost segregation outweigh the additional tax due to recapture when the taxpayer holds the property for greater than three to five years.
- Improved investment returns: Cost segregation can help improve the overall return on investment for ADUs by reducing the tax burden and increasing cash flow.
A Real World Example of Cost Segregation in Action
To illustrate the potential advantages of cost segregation, we’re going to take a look at a real world example that one of our clients used to dramatically reduce their tax liability.
Our client added an ADU to their multifamily building in the San Francisco Bay Area in July 2021. Utilizing a cost segregation study, they realized significant tax savings in the first year by reclassifying specific building components for faster depreciation as the building was placed into service.
- Partnering with Adapt Dwellings and our specialty tax partner, Veritax Advisors, we conducted an on-site inspection to physically view all the property’s assets.
Standard depreciation for residential investment real estate is based on a 27.5 year schedule. The study’s results showed that 76% of the property was still considered “real property,” still belonging to the normal depreciation schedule.
However, nearly a quarter of the property could be reclassified as 5-year or 15-year property for faster depreciation, including 20% now classified as personal property (cabinets, plumbing, etc.) and 4% as land improvements (paving, landscaping, etc.).
With nearly 25% of the property reclassified for faster depreciation, our client will save as much as $118,000 in taxes.
While it may seem hard to believe, cost segregation is a perfectly legitimate tax strategy that real estate investors like yourself can use to their advantage to lower their tax burden over time.
Conclusion
Cost segregation can be a powerful tax strategy for real estate investors looking to maximize the tax benefits of their ADUs in California. Accelerating depreciation deductions and reducing tax liability can improve after-tax cash flow and investment returns. As they say, “It is not how much you make, but how much you keep that matters.”
If you’re considering cost segregation for your ADU, Adapt Dwellings and Veritax Advisors are here to help. Adapt Dwellings is a leader in the Bay Area ADU industry and Veritax Advisors has helped many real estate investors optimize their tax savings on their newly constructed ADUs. Contact us today, and let us help you get started!
