Cost Segregation To Increase Your Rental Depreciation

• Cost Segregation Studies break out your rental components into different depreciation schedules

• Cost Seg­re­ga­tion Stud­ies often do not require an engi­neer to vis­it your prop­er­ty, mak­ing the cost much more afford­able than many real estate investors real­ize
• Cost Seg­re­ga­tion of rental prop­er­ties is actu­al­ly the CORRECT way to depre­ci­ate prop­er­ty, not the excep­tion to the rule (IRS allows 27.5 or 39 years because, in part, it’s more advan­ta­geous to the IRS)

What is a Cost Segregation Study?

A cost seg­re­ga­tion study is a detailed engi­neer­ing and tax analy­sis that breaks down the com­po­nents of a build­ing and improve­ments into dif­fer­ent asset class­es for depre­ci­a­tion pur­pos­es. Under the U.S. tax code, build­ings are typ­i­cal­ly depre­ci­at­ed over a long peri­od:

• Res­i­den­tial rental prop­er­ty: 27.5 years
• Com­mer­cial prop­er­ty: 39 years

Cost seg­re­ga­tion iden­ti­fies parts of the prop­er­ty that can be depre­ci­at­ed over much short­er peri­ods, such as 5, 7, 15, or 20 years, instead of the stan­dard 27.5 or 39 years. These short­er-lived assets might include:

• Floor­ing, car­pet­ing, and inte­ri­or fin­ish­es
• Light­ing fix­tures
• Elec­tri­cal sys­tems ded­i­cat­ed to appli­ances
• Plumb­ing and water heat­ing sys­tems
• Land­scap­ing (this includes trees and poten­tial­ly oth­er improve­ments to the raw land)
• Park­ing lots and relat­ed improve­ments
• HVAC sys­tems in spe­cif­ic areas

By reclas­si­fy­ing these assets, prop­er­ty own­ers can claim accel­er­at­ed depre­ci­a­tion, sig­nif­i­cant­ly reduc­ing their tax­able income in the ear­ly years of own­er­ship.

How Does a Cost Segregation Study Work?

A cost seg­re­ga­tion study typ­i­cal­ly involves the fol­low­ing steps:

1. Engage a Qualified Specialist

• The IRS requires a detailed analy­sis for cost seg­re­ga­tion. This is usu­al­ly per­formed by pro­fes­sion­als with exper­tise in engi­neer­ing, con­struc­tion, and tax law.
• A tax advi­sor can help deter­mine if a cost seg­re­ga­tion study makes finan­cial sense for your prop­er­ty.
• Gen­er­al­ly, a prop­er­ty own­er will max­i­mize the return on invest­ment if the study is per­formed ear­ly in own­er­ship, albeit it’s often still worth­while near the end just pri­or to a sale due to the abil­i­ty to make adjust­ments to cost basis, depre­ci­a­tion, and tak­ing prop­er­ty out of ser­vice.

2. Analyze the Property

• Engi­neers and tax spe­cial­ists exam­ine con­struc­tion doc­u­ments, blue­prints, invoic­es, and oth­er records to iden­ti­fy and seg­re­gate the build­ing’s com­po­nents.
• A phys­i­cal inspec­tion of the prop­er­ty may also be con­duct­ed to ensure accu­rate clas­si­fi­ca­tion.

3. Reclassify Assets

• Each com­po­nent of the prop­er­ty is assigned to the appro­pri­ate depre­ci­a­tion class:
  • 5‑year prop­er­ty: Per­son­al prop­er­ty (e.g., appli­ances, fur­ni­ture)
  • 7‑year prop­er­ty: Equip­ment (e.g., spe­cial­ized machin­ery)
  • 15-year prop­er­ty: Land improve­ments (e.g., side­walks, land­scap­ing)
  • 27.5‑year or 39-year prop­er­ty: Struc­tur­al ele­ments of the build­ing

4. File the Study with Your Taxes

• The results of the study are used to adjust depre­ci­a­tion sched­ules on tax returns. If the prop­er­ty was pur­chased in pri­or years, the IRS allows you to “catch up” on missed depre­ci­a­tion with­out amend­ing past returns.

Why is a Cost Segregation Study Important for Rental Property Owners?

1. Accelerates Tax Deductions

Depre­ci­a­tion is a pow­er­ful non-cash expense that reduces tax­able income. With cost seg­re­ga­tion, prop­er­ty own­ers can front-load depre­ci­a­tion deduc­tions:

• Exam­ple: Instead of wait­ing 27.5 years to ful­ly depre­ci­ate a $50,000 HVAC sys­tem, you might depre­ci­ate it over 5 years, claim­ing $10,000 annu­al­ly instead of $1,818.

This accel­er­at­ed depre­ci­a­tion frees up cash flow that can be rein­vest­ed into oth­er prop­er­ties, ren­o­va­tions, or pay­ing down debt. By def­i­n­i­tion, com­mer­cial prop­er­ty own­ers have the most flex­i­bil­i­ty and advan­tage by using a cost seg­re­ga­tion study to take greater depre­ci­a­tion soon­er due to the nature of oth­er­wise spread­ing the depre­ci­a­tion over 39 years.

2. Increases Cash Flow

By reduc­ing your tax­able income in the ear­ly years of prop­er­ty own­er­ship, a cost seg­re­ga­tion study low­ers your tax lia­bil­i­ty. This means you can keep more mon­ey in your pock­et, which can be crit­i­cal for scal­ing your real estate port­fo­lio or man­ag­ing oper­at­ing expens­es. As will be evi­dent below, often the sav­ings can be enough to allow an investor to buy addi­tion­al prop­er­ties using the tax sav­ings alone. For many rental prop­er­ty own­ers, the first years are the most dif­fi­cult to obtain a pos­i­tive finan­cial result, the abil­i­ty to poten­tial­ly off­set oth­er income, includ­ing non-pas­sive income (for some), is a game chang­er. Tak­ing a greater depre­ci­a­tion expense in the first few years is one poten­tial strat­e­gy to move the nee­dle pos­i­tive that few oth­er meth­ods offer.

3. Maximizes Benefits of Bonus Depreciation

The Tax Cuts and Jobs Act of 2017 intro­duced 100% bonus depre­ci­a­tion, allow­ing prop­er­ty own­ers to ful­ly depre­ci­ate assets with use­ful lives of 20 years or less in the year they’re placed in ser­vice. Cost seg­re­ga­tion unlocks this bonus depre­ci­a­tion by iden­ti­fy­ing qual­i­fy­ing assets:

• Exam­ple: If your study reclas­si­fies $200,000 of a build­ing com­po­nents into 5‑year prop­er­ty, you could deduct the full $200,000 (depends on how much bonus depre­ci­a­tion is allowed in any giv­en year, cur­rent­ly at 60% in 2024) in the first year. In 2021, it was high­er than 60% for exam­ple.

4. Provides a Retroactive Benefit

Even if you’ve owned a prop­er­ty for sev­er­al years, you can per­form a cost seg­re­ga­tion study and “catch up” on missed depre­ci­a­tion with­out amend­ing pri­or tax returns. This is done by fil­ing a Form 3115: Appli­ca­tion for Change in Account­ing Method, which allows you to claim the cumu­la­tive depre­ci­a­tion in the cur­rent year. This is, as any study is, gen­er­al­ly bet­ter ear­ly in the own­er­ship process vis-a-vis after 15+ years of own­er­ship. How­ev­er, let’s for exam­ple say you’re going to per­form a full remod on the prop­er­ty, well, that very well may change the facts enough to make it well worth­while and a mis­take if you’re not going to do so.

5. Improves ROI on Property Improvements

Cost seg­re­ga­tion also applies to ren­o­va­tions or improve­ments made after the pur­chase of the prop­er­ty. By seg­re­gat­ing the costs of these upgrades, you can imme­di­ate­ly ben­e­fit from accel­er­at­ed depre­ci­a­tion. THIS IS ESPECIALLY IMPORTANT FOR MAJOR IMPROVEMENTS, SUCH AS A ROOF REPLACEMENT. Addi­tion­al­ly, by using a cost seg­re­ga­tion study, you’re able to more eas­i­ly ascer­tain the amount of remain­ing life (if any) of prop­er­ty removed from ser­vice, such as a roof and/or oth­er items, which often are removed from ser­vice pri­or to being ful­ly depre­ci­at­ed. Addi­tion­al­ly, when com­po­nents are replaced, it adjusts your cost basis, help­ing to avoid depre­ci­a­tion recap­ture (which is gen­er­al­ly taxed at a high­er rate than cap­i­tal gains).

6. Mitigates Passive Loss Limits

For investors who active­ly par­tic­i­pate in real estate man­age­ment or qual­i­fy as Real Estate Pro­fes­sion­als (REPs) under the IRS def­i­n­i­tion, cost seg­re­ga­tion can help off­set oth­er tax­able income by gen­er­at­ing larg­er paper loss­es. How­ev­er, using short term rentals, it’s pos­si­ble that you may not have to have Real Estate Pro­fes­sion­al sta­tus to deduct real estate depre­ci­a­tion (tax loss­es) from your oth­er income (includ­ing non-pas­sive income). Hav­ing prop­er and com­pe­tent tax guid­ance is key to know­ing what expense lim­i­ta­tions you may take to ensure you’re not pay­ing more than you legal­ly have to in tax­es.

This is a big deal and can’t be overem­pha­sized, if you are not able to take the depre­ci­a­tion expens­es, either because your income is already so low it does­n’t make sense to use the expense this year, or you’re sub­ject to oth­er lim­i­ta­tions, for exam­ple, you’re not mate­ri­al­ly par­tic­i­pat­ing and/or you’re not a Real Estate Pro­fes­sion­al, and you make too much active income (ie over $150,000 in 2023), a cost seg­re­ga­tion study may be a waste of mon­ey, or at least a waste this year.

7. Strategic Tax Planning for Exits

Accel­er­at­ed depre­ci­a­tion low­ers your tax­able income dur­ing own­er­ship for most real estate investors (which is gen­er­al­ly the biggest moti­va­tor in invest­ing in a cost seg­re­ga­tion study). While it may increase the “recap­ture tax” when you sell the prop­er­ty, savvy plan­ning (e.g., 1031 exchanges) can defer or elim­i­nate the impact of recap­ture tax­es.

Who Should Consider a Cost Segregation Study?

Not all prop­er­ties ben­e­fit equal­ly from cost seg­re­ga­tion. The fol­low­ing fac­tors make a study more ben­e­fi­cial:

1. Property Value

• Prop­er­ties val­ued at $500,000 or more gen­er­al­ly see the great­est return on invest­ment (ROI) for cost seg­re­ga­tion stud­ies. How­ev­er, even small­er prop­er­ties may ben­e­fit if they con­tain a sig­nif­i­cant amount of short-lived assets.

2. Type of Property

• Res­i­den­tial rental prop­er­ties: Apart­ments, mul­ti­fam­i­ly prop­er­ties, and sin­gle-fam­i­ly rentals often con­tain numer­ous reclas­si­fied assets.
• Com­mer­cial prop­er­ties: Retail cen­ters, office build­ings, ware­hous­es, and hotels are prime can­di­dates.

3. Length of Ownership

• Cost seg­re­ga­tion pro­vides the most ben­e­fit ear­ly in the own­er­ship peri­od when you can max­i­mize accel­er­at­ed deduc­tions. How­ev­er, retroac­tive stud­ies are also valu­able for long-held prop­er­ties.

4. Tax Bracket

• Investors in high­er tax brack­ets ben­e­fit more from the imme­di­ate reduc­tion in tax­able income. As stat­ed pre­vi­ous­ly, if you’re income is already so low you’re not pay­ing much in tax, it may not make sense to spend more than you’ll save.

5. Real Estate Professionals

• Own­ers who qual­i­fy as Real Estate Pro­fes­sion­als under the IRS rules can use cost seg­re­ga­tion to off­set income from oth­er sources, mak­ing it espe­cial­ly advan­ta­geous.

Potential Risks and Considerations

While cost seg­re­ga­tion offers sig­nif­i­cant ben­e­fits, there are some risks and con­sid­er­a­tions to keep in mind:

1. Cost of the Study

• A cost seg­re­ga­tion study typ­i­cal­ly costs between $5,000 and mil­lions of dol­lars (and it’s impor­tant to shop around to find the best option for you and your prop­er­ties), depend­ing on the com­plex­i­ty and size of the prop­er­ty. Ensure the pro­ject­ed tax sav­ings jus­ti­fy the expense.

2. Depreciation Recapture Tax

• Accel­er­at­ed depre­ci­a­tion reduces tax­able income dur­ing own­er­ship but may increase the depre­ci­a­tion recap­ture tax when you sell the prop­er­ty. Plan­ning strate­gies like 1031 exchanges can help defer this tax.

3. IRS Scrutiny

• Cost seg­re­ga­tion stud­ies must fol­low strict IRS guide­lines. Engag­ing a qual­i­fied pro­fes­sion­al ensures com­pli­ance and reduces the risk of audit penal­ties. Below, I have includ­ed an IRS Cost Seg­re­ga­tion Audit Tech­nique Guide.

4. Cash Flow Timing

• Front-load­ing depre­ci­a­tion may reduce future deduc­tions, so care­ful cash flow plan­ning is essen­tial.

Case Study: How Cost Segregation Benefits Rental Property Owners

Scenario (example for concept illustration purposes only):

• Prop­er­ty: Res­i­den­tial apart­ment com­plex
• Pur­chase Price: $2,000,000 (build­ing val­ue: $1,500,000; land val­ue: $500,000)
• Depre­ci­a­tion With­out Cost Seg­re­ga­tion:
  • Annu­al depre­ci­a­tion: $1,500,000 ÷ 27.5 years = $54,545

With Cost Segregation:

A study reclas­si­fies $400,000 of the build­ing val­ue as 5‑year prop­er­ty and $200,000 as 15-year prop­er­ty:

• 5‑Year Depre­ci­a­tion: $400,000 ÷ 5 = $80,000/year
• 15-Year Depre­ci­a­tion: $200,000 ÷ 15 = $13,333/year
• Remain­ing $900,000 depre­ci­ates over 27.5 years: $32,727/year

Total Depre­ci­a­tion in Year 1:

• $80,000 + $13,333 + $32,727 = $126,060

Com­pared to the stan­dard $54,545, the prop­er­ty own­er claims an addi­tion­al $71,515 in depre­ci­a­tion deduc­tions in the first year, sig­nif­i­cant­ly reduc­ing tax­able income and increas­ing cash flow.

How to Get Started with a Cost Segregation Study

1. Assess Feasibility

• Work with a tax advi­sor to deter­mine if a cost seg­re­ga­tion study makes sense for your prop­er­ty based on its val­ue, age, and your tax sit­u­a­tion.

2. Engage a Qualified Professional

• Choose a rep­utable firm spe­cial­iz­ing in cost seg­re­ga­tion with expe­ri­ence in engi­neer­ing, con­struc­tion, and tax com­pli­ance. There are many to choose from, albeit you want to make sure the pro­fes­sion­al knows what they’re doing, and you can count of the results.

3. Plan Strategically

• Coor­di­nate with your tax advi­sor to inte­grate the study into your broad­er tax strat­e­gy, con­sid­er­ing fac­tors like bonus depre­ci­a­tion, real estate pro­fes­sion­al sta­tus, and planned prop­er­ty sales.

A cost seg­re­ga­tion study can be a pow­er­ful tool for rental prop­er­ty own­ers seek­ing to max­i­mize tax sav­ings and improve cash flow. By accel­er­at­ing depre­ci­a­tion, it allows investors to rein­vest in their port­fo­lios, reduce tax bur­dens, and strate­gi­cal­ly plan for the future. While it requires an upfront invest­ment and care­ful plan­ning, the long-term ben­e­fits often far out­weigh the costs.

If you own rental prop­er­ties, con­sult with a tax pro­fes­sion­al to explore how cost seg­re­ga­tion can trans­form your invest­ment strat­e­gy and take your real estate busi­ness to the next lev­el. If you would like to sched­ule a con­sul­ta­tion regard­ing your real estate invest­ments, or if you’re plan­ning on enter­ing into real estate invest­ments, we’re hap­py to talk with you.

IRS_Cost_Segregation_Audit_Technique_Guide_Publication_5653 updat­ed 2022