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ContinueCost segregation in real estate allows investors to accelerate their depreciation to decrease tax liabilities in the earlier years of owning their investment property.
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Written by
Ben Luxon
PUBLISHED ON
25
Jan
2024
While you may be familiar with depreciation many investors are less familiar with cost segregation. However, it’s an important tool for investors to come to grips with alongside their depreciation, as, in the right scenario it can help you increase your rental property profitability.
Cost segregation in real estate is a term that refers to the practice of segmenting different components of a property’s depreciation. It’s a strategy that investors use to maximize their depreciation deduction in the early years of owning a rental property. This can help improve cash flow and increase profitability during a period when operating costs are typically higher.
The real estate depreciation deduction is typically spread over what the IRS deems its ‘useful life’. For residential real estate, this is 27.5 years and for commercial it’s 39 years. However, cost segregation allows investors to accelerate this depreciation schedule. This acceleration increases the annual deductible amount, leading to a reduction in income tax obligations in the initial years of owning and operating your rental.
This real estate tax strategy applies to a range of properties, including single-family homes, office buildings, or retail storefronts, against their taxable income. However, it’s important to note that it is exclusively for use for properties owned as investments - not private residences.
To implement cost segregation, investors must first initiate a cost segregation study which will determine the assets that can be split out from the building’s overall value and the independent depreciation schedules for each.
"Depreciation" refers to the decline in value of something over time, contrasting with "appreciation," which denotes an increase in value over a period.
In the tax realm, depreciation is categorized as a non-cash expense, indicating that it is an accounting entry rather than an actual out-of-pocket cost. Despite not involving a direct cash expenditure, the IRS permits the deduction of this expense against your taxes.
Businesses can deduct depreciation expenses for assets acquired for business use as long as they adhere to the IRS guidelines governing the process.
When and how can you use cost segregation in real estate though?
The initial requirement for claiming depreciation on real estate involves being the owner of the property. Ownership is recognized even when the property is encumbered by a lien, such as a mortgage owed to a lender (since you are responsible for property taxes).
If the property is utilized for business purposes or generates income, such as rental income, it becomes eligible for depreciation.
As per IRS regulations, residential income-producing property is eligible for depreciation over a span of 27.5 years starting from the date it is put into service (ie. when it becomes available for rent).
For instance, if you acquire a single-family investment property on March 1st, spend two months on renovations and then make it available for rent on May 1st, and initiate a lease with a tenant on June 1st, it is the date of May 1st that becomes the starting point for depreciating the property.
In cases where your primary real estate income stems from house flipping, your properties do not meet the criteria for depreciation. However, if you transition to becoming a landlord and rent out the property, considering a cost depreciation study may be beneficial for the tax savings associated with depreciation.
Applying the straight-line method of depreciation, where the total depreciation expense is evenly spread across the entire useful life of the asset and without considering your specific income tax bracket, let's consider a scenario.
Suppose the following:
Under these conditions, the annual depreciation expense for your investment property amounts to $21,818.18 per year, spanning from January 1, 2019, through June 30, 2046 (calculated based on the $600,000.00 value of real estate improvements, as land is not depreciable).
Assuming the investment generates $30,000.00 in income for you in 2019, the income attributable to you for this investment in 2019 would be $8,181.82 ($30,000.00 income minus $21,818.18 depreciation expense). While this may seem advantageous, exploring how cost segregation can further enhance these benefits is worth considering.
Engaging in a cost segregation study involves a detailed analysis of the property, aiming to identify opportunities for categorizing assets and improvements into distinct classes for depreciation purposes.
Under this approach, land improvements can be depreciated over a span of 15 years, equipment over a five-year period, and the building itself over 27.5 years for residential real estate or 39 years for commercial real estate investing.
It's advised you engage a cost segregation specialist when exploring this real estate strategy.
Cost segregation studies offer insights on optimizing tax deductions for your investment property. It is advisable to enlist the services of a financial firm with demonstrated expertise in engineering, construction, tax law, and accounting to ensure a comprehensive cost segregation study.
The initial step in the cost segregation process involves a thorough analysis of your investment property to confirm its suitability for cost segregation. Your cost segregation team will examine various components of the property, such as plumbing fixtures, roofing, electrical systems, sidewalks, driveway, flooring, and other materials.
The rationale behind this analysis lies in the fact that if these items were acquired separately, the IRS tax code generally allows for depreciation over 5 to 15 years.
In a cost segregation study, engineering and financial experts categorize each part of the property separately, enabling an accelerated depreciation timeline for certain building features.
For the experts conducting the cost segregation study, obtaining several documents is crucial to ascertain the value of the building and its systems. This may include recent property appraisals, inspection reports, or closing documents from the purchase of your investment real estate.
Following the acquisition of necessary information, the team will identify any operating costs of the investment property that can be depreciated over 5, 7, or 15 years. This involves studying provided documents like blueprints, property records, and inspection reports.
Upon completing the property analysis, the team will compile a comprehensive report. This report serves as a valuable tool for determining the potential savings on income taxes through the application of cost segregation strategies.
Using the same multi-family rental property from our example earlier where.
As established, according to the straight-line depreciation method, you can deduct $21,818.18 per year, spanning from January 1, 2019, through June 30, 2046.
Now, if you opt for a cost segregation study, your team might uncover opportunities to depreciate specific components separately. For instance, $30,000 of the property’s plumbing fixtures could be depreciated over 5 years, $30,000 of electrical fixtures over 7 years, and $40,000 spent on the driveway, and other fixtures over 15 years
Following the cost segregation study, the building's recalculated value becomes $500,000, while the systems eligible for accelerated depreciation amount to $100,000. Armed with this information, you can now claim more significant depreciation over the first 15 years of owning the property.
Property - $18,181 for 27.5 years.
Plumbing - $10,000 for the first three years.
Electrical - $4,285 for the first seven years.
Other fixtures - $2,666 for the first fifteen years.
Whilst these numbers are for example purposes only, this example shows how in the first year you would be able to claim $35,132 in depreciation compared to $21,818.
It's crucial to note that cost segregation can only be performed once on any investment property that you own. You should also bear in mind that this does mean you will receive a lower depreciation deduction in the later years of owning the property. Plus, all depreciation claimed will be liable for depreciation recapture when you sell the property.
Before delving into the cost segregation example, let's address some common misconceptions surrounding cost segregation.
Misconception 1: "Cost segregation is not available for residential real estate." This assertion is incorrect. Cost segregation is applicable to all investment properties, regardless of whether they are utilized for commercial or residential purposes.
Misconception 2: "I will just pay back all of the depreciation later because of depreciation recapture when I sell." While there might be a depreciation recapture liability upon the sale of your investment property, the current depreciation recapture rate is 25%, which is still below the highest individual tax bracket (37% in 2024).
Depending on your tax bracket, the potential gains may outweigh the recapture costs. Additionally, front-loading depreciation allows you to maximize the time value of money, as having the use of money today is more valuable than having the same amount of money in the future.
Misconception 3: "A cost segregation study is too expensive." While cost segregation studies incur costs, the potential significant tax savings in the initial year from accelerated depreciation can offset these expenses. In essence, the study could pay for itself through the tax savings realized during the initial year of benefiting from accelerated depreciation.
Engaging in a cost segregation study becomes a practical consideration if you've acquired or constructed a real estate investment within the past 15 years. The applicability of cost segregation extends to both residential and commercial investment properties, ensuring that ownership of a single-family rental does not exclude you from the advantages of such a study.
While cost segregation may not be suitable for every investor, it proves beneficial when investors seek increased access to cash for further investment. For instance, if you currently own a rented single-family home and are contemplating the acquisition of an office building to expand your real estate portfolio, cost-segregating the depreciation of your single-family property can result in reduced taxes which in turn, frees up funds that can be utilized to facilitate the purchase of the office property.
You have the option to commission a cost segregation study at any point after acquiring, constructing, or renovating a property. However, the optimal timing for this is within the same year as your purchase, construction, or remodeling of investment real estate. This ensures that you maximize tax savings during the period when you are likely making significant expenditures on your real estate.
If you neglected to conduct a cost segregation study when initially constructing, purchasing, or remodeling a property, you still have the opportunity to leverage this tax strategy through a process known as a look-back study.
This particular type of cost segregation study enables you to assert a catch-up tax deduction. Upon the completion of the study, you can claim this catch-up deduction within a single year. The deduction amount corresponds to the disparity between your initial depreciation claim on the investment property and what you could have claimed had you executed the cost segregation study earlier.
According to IRS regulations, you are permitted to carry out a look-back study on properties that you bought, built, or remodeled as far back as January 1, 1987.
The primary advantage of cost segregation is its potential to generate savings. This is achieved through:
While cost segregation is a valuable tax tool for real estate investors, it does have a couple of drawbacks:
Cost segregation can be complicated. Here are some of the questions that most real estate investors have about this tax strategy.
In a cost segregation study, a team of tax and engineering experts will study the various components of a building – such as its wiring, plumbing, light fixtures, flooring and exterior improvements – to determine if you can accelerate the depreciation of some of them. By speeding up the depreciation schedule, you can reduce the amount of taxes that you pay on these properties in the years following your study.
The cost of a study will vary depending on the size and type of your property, but you can expect to pay from $5,000 to $15,000.
Tax and engineering experts take into account various factors when conducting a cost segregation study, resulting in a typical completion timeframe of at least one month. The specific duration for your team to finalize the study hinges on factors such as the property type, the size of your investment property, and your ability to furnish the necessary paperwork for the analysts. Generally, one can anticipate a cost segregation study to span between 30 to 60 days.
You can. But this isn’t recommended. You want to squeeze the greatest amount of tax savings from a cost segregation strategy. It’s best to rely on engineering and tax experts to do this.
Even with the high fees charged for a cost segregation study, using this tax strategy is typically a smart financial move. The amount in taxes you save each year following the study will more than cover the one-time fee of a study.
Whatever strategy you employ when it comes to reducing your tax liabilities and increasing your portfolio profits, there is one constant. You need to ensure you have the tools and processes in place to accurately account for all of you income and expenses and maximize your tax deductions.
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