As we pointed out yesterday, cost segregation (CS) is a tool allowing the investor to maximize potential cash flow by means of a more detailed study of their property — in terms of depreciation.

The following is a concept sounding simplistic until you think about it. I impart it several times to clients until it becomes part of their own thinking. It’s what investing is all about if looked through the narrow prism of money and time — or money vs time.

More is better than less. Sooner is better than later. mo’ sooner is much mo’ better.

Ultimately, the goal of CS is simple — to increase cash flow through tax reduction — savings. It can also contribute mightily to the significant reduction of capital gains taxes in the sale of your investment property. Why let the IRS guy prance happily around with your money?

Let’s say you recently purchased a four million dollar apartment building. The improvements (building) by code will be depreciated using a 27.5 year schedule. In this case if we impute a 20% land value, resulting in a $3.2Mil building value, your annual depreciation would be an inch over $116K yearly. Most of my clients are in the blended fed/state tax rate of 30-40%. We’ll use 35%.

This means they’d save close to $41K in taxes on the property’s cash flow and/or their ordinary income. ‘Not bad’ you say. Let’s make the assumption your annual cash flow before taxes (income taxes) is $100K.

Now let’s look at the impact CS can have.

You hire Cost Segregation Unlimited (fictional) who agree to provide you with a fully detailed and documented report. This report will result in dramatically increased depreciation. Also, it will be defended if necessary against any IRS challenge — at no additional fee. When done correctly, using specialists, challenges virtually don’t exist — especially successful challenges.

So they do the report and you see they’ve uncovered a total of $300K in depreciation!

Holy write-off Batman!

This now means that all of your $100K cash flow is tax sheltered. It also means that you’ll have a bunch left over for your ordinary (job) income, if you don’t make too much. If your job income is too much according to the code, the extra $200K of yearly unused write-off will be ‘brought forward’ and begin accumulating year by year.

Don’t fret — that’s not a bad scenario for you.

If you hold that property for five years and sell it for $5.5Mil — a pleasant surprise might be in store for you. In those same five years you accumulated roughly $1Mil of unused depreciation which can be applied to long term capital gain. I won’t bore you with all the numbers here, but suffice to say you’d end up paying almost no taxes. And you’d be dancing while you wrote the check for the pitifully small amount you did have to pay.

In this example, $12K made it possible to receive $500K or more in totally tax sheltered cash flow, and pay little or no capital gains taxes on a seven figure profit. Come to think of it, a nickel for that Snickers was a lot of money wasn’t it?

Part III will talk about applying CS years after buying the property — How to change accounting methods with the IRS — And what happens when you take retroactive depreciation.