It’s safe to say that no one likes paying taxes. That’s why it’s important to do some tax planning each year to make sure that you’re not missing out on legal deductions you may be entitled to. One powerful strategy that may help investors reduce their tax bill is a cost segregation study. If you own rental properties, this is a way to deduct depreciation faster and take more losses now, in the early years of owning your rentals. Let’s take a look at what it’s all about.
What is depreciation?
First, let’s cover the basics. What is depreciation in taxes?
Depreciation refers to how much an asset decreases in value over time. You can deduct this depreciation, therefore reducing your tax liability.
What is a cost segregation study?
Generally, when you place a rental property into service, the land and building values are separated based on what the county assessor has determined. Then the building portion is depreciated over 27½ years (residential property) or 39 years (commercial property). The term “building” is a bit misleading because it generally includes a lot more than just the building. While the building value does include structural components, it also includes light fixtures, cabinets, fences, flooring, and other items that have a much shorter life than 27½ years—especially in rentals.
With cost segregation, you can reclassify a portion of your assets as personal property instead of real estate property to depreciate them on a much, much faster schedule (such as five, seven, or 15 years) for tax purposes. This strategy is also referred to as “accelerated depreciation.” It’s a great tax planning strategy used by real estate investors to reduce their current tax liability and increase cash flow.
How does it work?
The study should be completed by a professional who can give the analysis and consider the effects on taxes. You will need to do the work to find them and then pay them a fee, usually $10,000–$12,000, but this might be a small piece of your eventual profit.
The professional will examine certain interior and exterior components of the property and assess their value and expected depreciation.
There are reputable companies that do cost segregation utilizing the engineering approach, which the IRS considers the most accurate and defensible. Better to be safe than sorry!
How much can you really save?
Cost segregation studies are worth the extra work. They can save you thousands of dollars on your tax bill each year!
Here’s an example using Joe the Real Estate Investor in two scenarios. On the left, he uses straight-line depreciation over 27.5 years. On the right, he uses cost segregation.
Here are the basic stats:
- Purchase price: $345,098
- Property basis: $310,588, after land has been carved out
- Passive income: $45,000
- Operating expenses: $10,000
|Depreciation without cost segregation||Depreciation with cost segregation|
|Straight-line depreciation: $11,294||Segregated depreciation: $33,791|
|Taxable income: $23,706||Taxable income: $1,209|
|Taxes: $5,215||Taxes: $266|
The total tax savings with cost segregation? $4,949.34! Not too shabby. Remember, this is an annual savings amount—imagine what that number will be over time for property owners!
More on tax deductions from BiggerPockets
Benefits of cost segregation
Cost segregation is a strategy for taxpayers that accelerates the depreciation of certain components of real property. For real estate investors, benefits include reducing their current tax liability, which results in upfront cash flow.
A few examples of components found in a multifamily property that are eligible for cost segregation depreciation include:
|Item||Asset classe||New life|
|Parking lot||Land improvements||15 years|
|Lawn sprinklers||Land improvements||15 years|
|Carpeting||Distributive trades & services||5 years|
|Kitchen stove||Distributive trades & services||5 years|
Put simply, a huge benefit to cost segregation is offsetting passive income through accelerated depreciation!
To give you the bigger picture, here’s a before-and-after example of a multifamily unit that utilized cost segregation:
|MACRS property class||Original basis||Accumulated depreciation||Reclassified basis||Revised accumulated depreciation|
The accumulated depreciation without cost segregation is $3,636. But with cost segregation, it’s $315,622. That’s a difference of $311,986 in accumulated depreciation!
The enactment of the Tax Cuts and Jobs Act (TCJA) of 2017 allowed 100% bonus depreciation within the first year of owning a property. With this, cost segregation is even more valuable to real estate investors.
The downsides to cost segregation studies
That said, there are drawbacks to cost segregation too.
Let’s use an investor named Nick as an illustration. He contacted a cost segregation firm after reading online about the wonderful benefits of this strategy. Nick was a smart guy and had done his own taxes for years. After getting the cost segregation study done, Nick was extremely happy to find out that he could double his depreciation deduction. He purchased a $700,000 commercial building, and the result of the cost segregation was that it would double his depreciation by increasing it from $19,000 to $40,000 by splitting part of his building into five- and 15-year assets. It doesn’t stop there: Nick believed he would benefit from the accelerated depreciation for several years since it would take time to fully depreciate the five- and 15-year property.
However, cost segregations are not guaranteed successes, and they are also not free. Nick spent around $5,000 to have the study done for the property, and it did gain him over $20,000 of deductions. His study actually doesn’t seem too pricey compared to the tens of thousands of dollars that some investors spend to have multiple properties done. Therefore, make sure that the cost segregation is actually worth the price you pay.
You might be thinking that Nick got a great benefit from his cost segregation. But you’d be wrong! In the end, he received no current year benefit from this study and missed out on reducing his 2014 tax bill by about $6,500 due to just one oversight. What was the mistake, you ask? Nick did not qualify as a real estate professional. His additional $20,000 of real estate deductions will now carry forward indefinitely until he qualifies to take the losses when one of these occurs:
- Nick or his wife qualifies as a real estate professional.
- His W-2 income falls below the $150,000 threshold.
- He sells the property.
That’s not to say that you have to be a real estate professional to benefit from cost segregation, although it may help in many situations. If your other income is below the $150,000 threshold or if your properties have significant income, then you may not need the real estate professional designation to benefit from cost segregation. Each situation is unique, and it is important to discuss your options with your CPA before hiring a cost segregation team.
The last downside is that several years from now, when the five-year and 15-year properties are fully depreciated, Nick’s depreciation deduction will be much smaller than what it would have been without the cost segregation. Instead of having a $750,000 building with $19,000 of depreciation each year, he may be left with a $544,000 building with $14,000 of depreciation each year.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Is cost segregation right for you?
Cost segregation benefits multifamily property investors or commercial property investors the most, especially those who hold the properties long term. It is a strategy that takes time.
It’s important to make sure you can actually take the deduction for the accelerated depreciation. Also, double-check that the benefit of cost segregation will be greater than the cost of the study.
Find a tax professional to assist you in cost segregation, especially one who will weigh the pros and cons of your individual situation.
When should a cost segregation study be conducted?
A cost segregation study can be conducted anytime after the purchase or remodel of the property. For maximum tax benefits, it’s important to do the study within the same year as purchasing or remodeling it.
IRS standards for cost segregation studies
The IRS has specific standards for cost segregation studies outlined in their Audit Techniques Guide, a 115-page text to help their examiners. It’s important to understand these standards yourself if you are considering a cost segregation study. Also, you will want to hire professionals who know the tax laws to avoid any obstacles or additional audits.