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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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While many investors are familiar with depreciation as a tax benefit, fewer understand the powerful role that cost segregation can play in enhancing rental property profitability. In the right circumstances, cost segregation in real estate can help you increase cash flow and improve your overall returns, making it a valuable tool for real estate investors to master.
A cost segregation study involves breaking down a property into its individual components and assigning shorter depreciation timelines to certain assets. By accelerating depreciation for these split-out components, investors can reduce taxable income in the early years of ownership when operating expenses are typically at their highest, ultimately improving cash flow and financial flexibility.
In this article, we’ll walk you through everything you need to know about cost segregation studies—what they are, how they work, and why they’re beneficial. We’ll also provide a detailed cost segregation study example to help you see the potential tax savings in action.
Cost segregation is a tax strategy that enables real estate investors to accelerate the depreciation of an investment property—whether it’s a single-family rental, office building, or retail space—allowing them to offset taxable income more aggressively.
Under typical IRS rules, real estate depreciation is spread across the property’s useful life:
Cost segregation modifies this standard schedule by identifying specific components of the property (such as plumbing fixtures, electrical systems, and flooring) that can be depreciated over shorter periods, ranging from 5 to 15 years. This accelerated depreciation increases annual deductions in the early years of ownership, reducing tax liability when operating expenses are typically higher.
This strategy can be applied to a wide range of property types, including residential rentals, commercial buildings, and retail properties, but it’s exclusively for investment properties, not personal residences.
To take advantage of cost segregation, investors must conduct a cost segregation study, which involves a detailed analysis of the property to identify qualifying components and assign them to shorter depreciation schedules.
A cost segregation study offers significant financial benefits by accelerating depreciation, which boosts cash flow, particularly in the early years of ownership. This front-loaded depreciation allows property owners to leverage the time value of money, using early tax savings for reinvestment and increased returns.
However, the advantage may diminish for short-term holders, as early deductions are subject to depreciation recapture upon sale, potentially reducing initial gains. Therefore, while cost segregation is highly effective for long-term investors, those with shorter holding periods should carefully consider the potential recapture impact.
"Depreciation" refers to the reduction in an asset’s value over time, in contrast to "appreciation," which indicates an increase in value. In tax terms, depreciation is a non-cash expense—a deduction allowed by the IRS to reduce taxable income without requiring an out-of-pocket cost. For real estate investors, cost segregation offers a strategy to accelerate depreciation, increasing tax savings and cash flow during the early years of ownership.
Here’s how and when you can effectively use cost segregation in real estate to accelerate your rental property depreciation.
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 and cost segregation can be applied to maximize tax savings.
The IRS allows depreciation for residential income-producing properties over 27.5 years, starting when the property is placed into service (i.e., available for rent).
For example:
A cost segregation study can be done once the property becomes income-generating.
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, 2024, through June 30, 2051 (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.You can review the full cost segregation study example below.
Learn more about rental property depreciation here
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:
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, 2024, through June 30, 2051.
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.
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 means 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.
Some common misconceptions surrounding cost segregation include.
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:
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 your income and expenses and maximize your tax deductions.
Landlords that use Landlord Studio save an average of $500 more at tax time than they did when using spreadsheets or comparable property management software. And if that wasn't reason enough, Landlord Studio offers a free plan and will help you streamline every aspect of your rental management, from finding and screening tenants to collecting rent online, to managing your tax return.
Cost segregation can be complicated. Here are some of the questions that most real estate investors have about this tax strategy.
The primary objective of a cost segregation study is to identify property assets that can be depreciated over 5, 7, or 15 years, rather than the standard 27.5 or 39 years for real estate. Additionally, eligible assets can be further accelerated through bonus depreciation, which allows for an immediate write-off of a percentage of the asset’s cost—60% in 2024 and 40% in 2025.
To perform the study, your advisory team will review relevant property documents, such as purchase records, construction costs, and blueprints. They may also conduct a physical inspection of the property to accurately allocate costs and maximize your tax benefits.
The ideal time to perform a cost segregation study is in the year the property is acquired, constructed, or remodeled. That said, it’s never too late—property owners can opt for a look-back study at any point afterward. A look-back study allows you to retroactively claim missed depreciation deductions, with the benefit of applying those write-offs to your current tax return without needing to amend previous years' filings.
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.
Conducting a cost segregation study is not something most property owners can do on their own. These studies require specialized expertise, typically involving a team of tax professionals and engineers who analyze the property and determine which components can be reclassified for accelerated depreciation. This team assesses individual building elements and assigns costs to categories with shorter depreciation timelines.
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.
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