Real estate investors have used cost segregation for years to build their wealth. Many investors pay little or no taxes, even though they have enormous assets, thanks to that strategy. This has led some to believe that cost segregation is a tax loophole only for the wealthy.
But that’s not true. In fact, anyone who owns a property can benefit from cost segregation if they know how to apply it.
In this article, we’ll explain what cost segregation is and how it can help you. We’ll also provide examples of how it can improve your cash flow and discuss the advantages and disadvantages of using cost segregation for your rental property.
What is cost segregation on rental property?
Cost segregation is a tax strategy that allows real estate investors to speed up the depreciation of their properties for tax purposes. This means they can increase their depreciation expenses, which helps lower their tax bills when they file their tax returns.
A rental property typically consists of land and a building. According to IRS rules, you can depreciate the building over 27.5 years. For instance, if your building is valued at $800,000, you can deduct about $29,090 ($800,000/27.5) each year from your taxable income for depreciation over that period.
It’s important to note that around 20-40% of a building’s components may actually depreciate more quickly. These components include things like fences, electrical wiring, walkways, flooring, roofs, furniture, and appliances.
Cost segregation helps you take advantage of this by allowing those quicker-depreciating components to be written off over shorter time frames of 5, 7, or 15 years. To achieve this, cost segregation firms, which usually include engineers and accountants, conduct a detailed study to categorize the property into four main components:
- Land
- Building
- Land Improvements (such as walkways, fences, and flooring)
- Personal Property (like washing machines, dryers, furniture, and heaters)
While the main building will still depreciate over 27.5 years, the land improvements, personal property, and other components identified in the study can be depreciated much faster.
How cost segregation works
Suppose you purchase a 4-unit apartment valued at $1,000,000, with the building itself valued at $800,000. If you don’t conduct a cost segregation study, you can claim a depreciation deduction of roughly $29,090 each year over 27.5 years.
However, if you engage a cost segregation firm and they find that about 30% of your property can depreciate over a shorter period of 5 years, you could deduct $60,000 from your taxable income annually for the next 5 years.
Before and After Cost Segregation Comparison
Without Cost Segregation:
- Annual Depreciation: $29,090
With Cost Segregation:
- Total Property Value: $1,000,000
- Value Eligible for 5-Year Depreciation (30%): $300,000
- Annual Depreciation Write-Off: $60,000 (for 5 years)
Under the Tax Cuts and Jobs Act (TCJA) of 2017, investors were able to take advantage of 100% bonus depreciation for qualified property placed in service between 27 September 2017 and 31 December 2022. This allowed property owners to deduct the entire cost of certain assets in the first year rather than spreading it out over several years.
This immediate tax benefit significantly boosts your cash flow, providing you with extra funds that you can reinvest in your property to boost its value or use to acquire additional properties, lifting your cash flow.
It’s important to note, however, the bonus depreciation benefit is being phased out by 20% each year starting in 2023, with 80% available for 2023, 60% for 2024, and so on, until it is eliminated after 2026.
Benefits of doing a cost segregation study on a rental property
1. Immediate Access to Cash
One of the biggest advantages of cost segregation is that it gives you immediate access to cash. By using depreciation to lower your taxable income, you keep more money that would normally go to the IRS. This extra cash can be used to invest in more properties, helping you grow your income.
Moreover, since the value of the US dollar may weaken over the 27.5 years of depreciation due to inflation, many investors find cost segregation a smart way to build wealth over time
2. Possible Lower Insurance Premiums
Cost segregation can also help you trim your insurance costs. When you have detailed reports on all the components of your building, you can provide clear information about replacement costs to your insurance company. This helps the underwriter assess the risk of insuring your property more accurately.
Having a complete report on your property also supports any claims you may file, as it provides evidence to justify expenses related to repairs or replacements.
3. Tax Benefits
Cost segregation has tax benefits. You can use your depreciation expenses to lower the taxable income from your rental property. If you qualify as a Real Estate Professional (REP), you can even use those deductions to lower your personal income tax.
If you don’t use the full amount of your depreciation in one year, you can carry over the remaining amount to future years for additional tax savings.
Drawbacks of doing cost segregation on a rental property
1. It Can Be Expensive
A good cost segregation study must be done by a qualified professional, often an engineer from a specialized firm. Because of this expertise, the cost of a study can be quite high, typically ranging from $5,000 to $15,000. The price depends on factors like the size and type of the property and other physical characteristics.
2. Depreciation Recapture When Selling
Although a cost segregation study may provide tax benefits at first, you will eventually need to pay taxes on any gains when you sell the property. If you didn’t use the money you saved wisely, this could heavily cut into your profits.
Many experienced real estate investors suggest using those tax savings to grow your portfolio. You might consider buying another rental property or reinvesting in your existing property to boost its value.
3. Penalties for Aggressive Studies
Even if you didn’t conduct the cost segregation study yourself, you could face a 20% negligence penalty on any tax underpayment if the IRS finds the study took an overly aggressive position. This often happens if you hire a firm that lacks the necessary expertise.
4. Limits for Non-Real Estate Professionals
There are restrictions on how non-real estate professionals can benefit from a cost segregation study. They can only use it to cut down taxable income from their rental property, meaning you need to have an occupied, income-generating property to qualify.
There’s also a limit on how much depreciation you can use to offset income in the first year. Real estate professionals can take advantage of bonus depreciation for immediate tax benefits, while non-professionals may have to wait several years to receive the same amount of tax relief.
Conclusion
Although a cost segregation study can boost your rental property portfolio, there are some drawbacks to keep in mind.
One major downside is the upfront cost of hiring a firm to conduct the study. This expense can be big, and it’s important to weigh it against the tax benefits you may receive. Another consideration is that you may be held responsible for penalties if the cost segregation study takes aggressive positions that the IRS might challenge. This shows the importance of choosing the right firm.
When selecting a firm for your cost segregation study, hire one with experience and a solid understanding of IRS guidelines. This will help you maximize the benefits of the study while minimizing the risk of penalties.
