It’s safe to say that nobody likes to pay taxes. Because of this, it is important to do some tax planning each year to ensure you don’t miss out on any statutory deductions that you may be entitled to. One powerful strategy that can help investors reduce their tax burden is a cost segregation study. If you own rental property, this will allow you to take the depreciation off faster and take more losses now in the first few years of your rental home. Let’s take a look at what it’s all about.
What is depreciation?
First, let’s cover the basics. What is tax depreciation?
Depreciation is how much an asset depreciates in value over time. You can deduct this depreciation and thus reduce your tax liability.
What is a cost separation study?
In general, when a rental property is commissioned, the property and building values are separated based on the findings of the district appraiser. The building component is then depreciated over 27½ years (residential real estate) or 39 years (commercial real estate). The term “building” is a bit misleading as it usually encompasses much more than just the building. While building value includes structural components, it also includes lighting fixtures, closets, fences, floors, and other items that have a lifespan much shorter than 27.5 years – especially in rental homes.
With cost segregation, you can reclassify some of your assets as personal property instead of real estate so that you can write it off much, much faster (e.g., five, seven, or 15 years) for tax purposes. This strategy is also known 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 carried out by a professional who can perform the analysis and consider the tax implications. You have to do the work to find them and then pay them a fee, usually $ 10,000 to $ 12,000, but this can be a small part of your future profits.
The expert examines certain interior and exterior parts of the property and assesses their value and expected depreciation.
There are reputable companies that perform cost segregation using the engineering approach that the IRS deems to be the most accurate and defensible. Better to be sure 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 every year!
Here is an example with 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 separation.
Here are the basic statistics:
- Purchase price: $ 345,098
- Real estate base: $ 310,588 after the land was excavated
- Passive income: $ 45,000
- Operating expenses: $ 10,000
|Depreciation without cost separation||Depreciation with cost separation|
|Straight-line depreciation: $ 11,294||Separate Depreciation: $ 33,791|
|Taxable Income: $ 23,706||Taxable Income: $ 1,209|
|Tax: $ 5,215||Tax: $ 266|
The total tax savings with cost separation? $ 4,949.34! Not too shabby. Remember, this is an annual savings amount – just imagine how many homeowners will have that number over time!
Learn more about BiggerPockets tax deductions
Benefits of cost segregation
Segregation of costs is a strategy for taxpayers that accelerates the depreciation of certain components of real estate. Benefits for real estate investors include reducing their ongoing tax liability, resulting in upfront cash flow.
Some examples of components in an apartment building that are eligible for segregated depreciation are:
|items||Asset class||New life|
|parking spot||Soil improvements||15 years|
|Lawn sprinkler||Soil improvements||15 years|
|Carpeting||Trade & Services||5 years|
|Kitchen stove||Trade & Services||5 years|
Put simply, a great advantage of cost segregation is that it can offset passive income through accelerated depreciation!
To give you a bigger picture, here is a before and after example of a multi-family unit that uses cost segregation:
|MACRS property class||Original base||Accumulated depreciation||Reclassified base||Revised accumulated depreciation|
|5 year property||N / A||N / A||$ 228,834||$ 228,834|
|15 years of ownership||N / A||N / A||$ 84,576||$ 84,576|
|27.5 years of ownership||$ 800,000||$ 3,636||$ 486,590||$ 2,212|
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 passing of the Tax Cuts and Jobs Act (TCJA) of 2017 enabled a 100 percent bonus write-off within the first year of owning a property. This makes cost separation even more valuable for real estate investors.
The disadvantages of cost segregation studies
However, the cost separation also has disadvantages.
Take an investor named Nick as an example. After reading online about the wonderful benefits of this strategy, he contacted a cost separation company. Nick was a smart guy and had paid his own taxes for years. After completing the cost separation study, Nick was delighted to have doubled his depreciation amount. He bought a $ 700,000 commercial building, and the result of cost segregation was that dividing part of his building into five- and 15-year assets doubled his depreciation from $ 19,000 to $ 40,000. It doesn’t stop there: Nick believed he would benefit from accelerated depreciation for several years as it would take time to fully depreciate the five and 15 year property.
However, cost separation is not a guarantee of success and is also not free of charge. Nick spent around $ 5,000 to have the study done on the property and it earned him over $ 20,000 in deductions. His study actually doesn’t seem too expensive compared to the tens of thousands of dollars some investors spend to build multiple properties. So make sure that the cost segregation is actually worth the price you pay.
You may think Nick got a lot of benefit from his cost separation. But you are wrong! He ended up getting no benefit from that study for the current year and, due to just one oversight, missed cutting his 2014 tax bill by about $ 6,500. What was the mistake you ask? Nick didn’t qualify as a real estate professional. His additional $ 20,000 in real estate deductions will now be carried forward indefinitely until he qualifies to assume the losses if any of the following occurs:
- Nick or his wife are qualified as real estate professionals.
- His W-2 income falls below $ 150,000.
- He’s selling the property.
That doesn’t mean you have to be a real estate professional to benefit from cost segregation, although it can help in many situations. If your other income is less than $ 150,000 or your real estate has significant income, you may not need a real estate job title 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 final drawback is that in a few years, when the five and 15 year properties are fully depreciated, Nick’s depreciation allowance will be much less than it would have been without the cost segregation. Instead of having a $ 750,000 building with an annual depreciation of $ 19,000, he may have a building worth $ 544,000 with an annual depreciation of $ 14,000.
Afraid of the tax season?
Unsure how to maximize the 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 get your taxes done this year – but also to prepare an ongoing strategy that will make your next tax season so much easier.
Is Cost Segregation Right For You?
Multi-family property investors or commercial property investors benefit most from cost segregation, especially those who hold the properties for the long term. It’s a strategy that takes time.
It is important to make sure that you can actually take the accelerated depreciation allowance. Also, check whether the benefits of cost segregation are greater than the costs of the study.
Find a tax advisor who can help you segregate costs, especially one who weighs the pros and cons of your individual situation.
When should a cost separation study be carried out?
A cost separation study can be carried out at any time after the property has been purchased or converted. For maximum tax benefits, it is important to conduct the study in the same year as the purchase or remodel.
IRS Standards for Cost Segregation Studies
The IRS has specific standards for cost segregation studies to be included in their Guide to Exam Techniques, a 115-page text to aid their examiners. It is important to understand these standards for yourself when considering a cost separation study. Also, hire professionals who know the tax laws to avoid obstacles or additional audits.