Finances

A Financial Analysis to Do Before Buying or Building Practice Real Estate

By Adam Cmejla, CFP®

Jan. 20, 2021

Accelerating Tax Deductions and Increasing Cash Flow Using a Cost Segregation Study

If I’ve said it once, I’ve said it 1,000 times: cash flow is king. One of the ways to manage cash flow in the practice is by understanding tax strategies that can benefit you as a practice owner. Remember, there’s an opportunity cost for every dollar that’s paid in taxes. Said another way, and because of the time value of money, a dollar in your practice today is worth a lot more than a dollar in your practice XX number of years down the road.

While there are many different ways to use depreciation in your practice as a way to harness the power of cash flow, another strategy exists if you currently own, or are in the process of building or purchasing, real estate: a cost segregation (“cost seg”) study.

What Is a Cost Segregation Study?
A cost segregation study is a process by which a commercial building hires a firm that specializes in the various depreciation schedules associated with commercial real estate.

In the absence of a cost seg study, normal commercial real estate is depreciated over a 39-year schedule, which means that you get to allocate part of that building as a depreciation expense against your business income each year…for 39 years. However, not all of the property that’s part of that commercial real estate is actual 39-year property. A cost segregation study will reclassify assets in the building that are eligible for five-, seven- or 15-year property, thus optimizing the use of depreciation on a per-year basis.

Benefits to Tax Payer
What’s the benefit to the taxpayer? The more depreciation expense you can capture in a given year, the higher your total deductions will be in a given year, lowering your tax bill, and thus, improving the net cash flow available to you each year.

Take this example. Let’s say you have a $1,000,000 that is going to be depreciated over a 39-year depreciation schedule. Based off IRS MACRS depreciation schedule, this equals a full year’s deduction in the amount of $25,641.

But if you enlist the services of a firm to perform a cost seg study, you well could have additional depreciation expense that can be accelerated forward. While the specifics of the building would influence the actual numbers that would be calculated, it wouldn’t be uncommon to see the first five years’ depreciation expense be anywhere from 2-3x the 39-year’s straight-lined method illustrated above.

It’s also important to understand that you don’t have to do a cost seg study in the year in which you’ve purchased the building. If you’ve purchased or built the building within the last couple of years, it would be worth exploring a cost seg study on your building.

The important concept to understand about a cost seg study, though, is that any property that is depreciated and then sold at some point in the future will be subjected to a 25 percent recapture tax rate for 1250 property or higher for 1245 property. This can possibly be mitigated and minimized through knowledgeable tax planning and a collaborative relationship with your CPA and other advisor, so the importance of involving your team before you make any decisions is paramount.

Doing a cost seg study can also be costly ($5,000 – $15,000+) to the building owner, so it’s important to understand whether the benefit is going to outweigh the expense. It’s also important to seek the advice of a cost seg study expert, and unless your CPA has another in-house expert that handles these requests for their clients, this is almost always not going to be the CPA that you use to prep your normal personal and practice returns.

While we don’t do this in-house for our clients, we do have established relationships with firms that have helped our clients, so please reach out if you’re interested in learning more, and we can make a connection and introduction on your behalf.

Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com/ebooks/ and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.

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