Rental property being built and under construction for real estate professional status on tax
Business Tax, Real Estate Tax, Rental Property

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