Why You Should Consider Doing a Cost Segregation Study | Resident First Focus

People often tout the financial advantages of owning a rental property, from monthly cash flow to the yearly tax write-offs. Depreciation can be one of the most lucrative write-offs. The average rental property owner typically depreciates the property evenly over 27.5 years, which the IRS considers the “useful life” of the property.

However, what if you could depreciate components of your rental property faster? What if you could amortize some pieces of property in as little as five years, saving thousands of dollars a year in the process?

Well, you can. It’s possible thanks to what’s known as “cost segregation.”

According to the American Society of Cost Segregation Professionals, cost segregation is “the process of identifying property components that are considered ‘personal property’ or ‘land improvements’ under the federal tax code” and then separating those components from real property for tax purposes. In other words, cost segregation allows you to depreciate certain property assets over a shorter tax life – usually 5, 7, or 15 years.

Think about it this way: a single building consists of many parts: doors, windows, and roofs, plumbing, and HVAC systems, appliances, even shrubbery. Many of these parts outlive their lifespan well before 27.5 years. Doing a cost segregation study allows you to depreciate the various assets that make up the building over a more realistic lifespan. Front-loading depreciation results in significant savings and cash in your pocket that can be reinvested to grow your investment portfolio.

To determine what property is eligible, most investors will hire a CPA to conduct a cost-segregation study. The study segregates the costs of real estate into four basic categories: personal property, land improvements, building improvements, and land.

Personal property includes furniture, carpet, fixtures, window treatments, and appliances. It tends to have the shortest life; usually, a 5 or 7-year recovery period and is depreciated using the 200% declining balance method.

Using this approach, a 5-year property would depreciate by 40% each year instead of the 20% allowable under the straight-line method. For example, a 5-year asset worth $5,000 would depreciate $2,000 in the first year ($5,000 x 0.40). In the second year, the depreciation would shrink to $1,200 [($5,000 - $2,000) x 0.40]. The closer the asset gets to the end of its useful life, the less the owner can write off for depreciation. This is what is meant by “front-loading” depreciation.

Land improvements include sidewalks, paving, fences and landscaping. Land improvements are typically amortized over a 15-year recovery period using the 150% declining-balance method. This method uses the same logic as above, but instead of doubling the straight-line value, items are depreciated by a factor of 1.5.

Building improvements and land are usually depreciated over 27.5 years using the straight-line method. However, a cost segregation study can be used to separate individual components of the building. Let’s use the example of a roof. A new roof would usually be depreciated over 27.5 years even though most.

A cost segregation study can separate the roof from the rest of the building. When a roof is replaced, the un-depreciated balance can be deducted in the year that the roof is replaced—something an investor could not do if the building costs were lumped together. 

A cost segregation study will use the IRS’s General Depreciation System (GDS) to assign the “life” to each asset segregated.

What Does a Cost Segregation Study Entail?

One of the reasons some investors don’t use cost segregation studies is because they’re complicated—and expensive. The average study will run you anywhere between $5,000 and $30,000 depending on the size and type of the asset. The costs are high because the study usually requires a team of professionals, including a CPA, engineer, and construction cost estimator. 

The study usually begins with a site visit. The consultant will visit your rental property to take an inventory of the assets. They’ll take measurements, pictures and other forms of documentation. Then they’ll collect spending data based on every aspect of construction such as materials, plumbing, electrical, and so on. That information will be used to classify property and analyze it using up to six different cost methods. The final report includes asset schedules, costing data, certification, and legal citations and exhibits that you’ll need as proof for the IRS.

Benefits of a Cost Segregation Study

The end goal for savvy real estate investors is to shelter as much rental income as possible from taxes. That’s why cost segregation studies are so impactful. Here are some of the benefits of cost segregation:

· More money back in your pocket on the front end. Purchasing a rental property requires a significant capital investment, from the 25-30% down payment to closing costs. By accelerating depreciation, investors can recover some of their capital in the first few years they own the property. Whether you use this savings to replenish your savings account, for operating expenses, or use this money to reinvest in additional property – there’s the only upside. 

· Carry losses forward. On paper, you may realize losses by accelerating depreciation. This is a good thing for investors because they can save much money in the short-term while carrying those losses forward to be applied to their tax burden in future years.

· Insurance cost savings. Provide a copy of your cost segregation study to your insurance provider. The study will help your insurance company better understand and focus its risk to more accurately underwrite insurance costs, potentially saving you thousands of dollars in the process.

· Compounding tax-free income. By accelerating depreciation, investors can necessarily generate tax-free income — the benefits of this compound over time. If you hold a property for long enough, you’ll eventually run out of depreciation. However, you can sell that asset and reinvest the proceeds into a like-kind investment through a 1031 exchange. Not only do you avoid paying capital gains tax, but you start depreciating all over again. Investors who play this game in perpetuity can defer paying taxes while building equity and socking away cash flow.

What’s surprising is how few apartment owners are aware of cost segregation. Don’t overlook its benefits. Whether you’re an active investor or a passive investor, these studies can be a powerful way for investors to grow your real estate portfolio.