Imagine walking into your front yard making a beeline straight to your landscaping and picking your finest, most pristine bush. Sure it’s nice to marvel at how photosynthesis breathes life into plants but what if I told you that this bush, besides being a marvel of Earth, could save you a tremendous amount of money on your taxes? Cost segregation done properly, can turn this bush, if treated correctly, into one of the smartest investment decisions you’ve made in your life.
What is a cost segregation study?
A cost segregation study is a method used by real estate owners to reduce their taxes by speeding up how quickly they can write off the value of a property. Think of a building as a bunch of different pieces put together—walls, floors, lighting, plumbing, and more. Normally, you would write off (depreciate) the entire property over a long period—27.5 years for a rental home or 39 years for a commercial building. Cost segregation breaks down the building into different parts, and some of these parts can be written off much faster, like over 5, 7, or 15 years. This means you get more tax deductions sooner, which can save you a lot of money in the short term.
It’s one of the least used yet most advantageous tax loopholes for real estate investors around. Many people assume that only developers or owners of large buildings and apartment complexes can benefit from cost segregation if they’ve even heard of it but it’s not so! In fact, any homeowner on planet Earth who is not planning on selling their home in the immediate future can benefit IMMENSELY from cost segregation.
How does depreciation work?
To understand cost segregation, it’s important to first understand depreciation. Depreciation is a tax deduction that lets you recover the cost of a property over time with the assumption that people need to continually invest in the upkeep, maintenance, and general integrity of the property. When you buy a property, you can’t deduct this whole cost in one year. Instead, you spread the cost over many years. This spreading out is called depreciation, and in many cases called, “straight-line depreciation”
How do you calculate depreciation?
It’s pretty simple, the IRS has 2 classifications for typical straight-line depreciation.
Property Type | Depreciation Period (Years) | Tax Savings Formula |
---|---|---|
Residential & Multifamily | 27.5 | Property Price / 27.5 = Tax Deduction |
Commercial | 39 | Property Price / 39 = Tax Deduction |
You simply divide the property price by the years and each year you can deduct this amount from taxable income.
For example, if you buy a rental property for $1 million, you might depreciate it over 27.5 years. This means you can deduct about $36,364 from your income every year. Depreciation recognizes that a building wears out over time, and this “wear and tear” is used to reduce your taxable income. You can see below, that every single year, you reduce your income by around $36,000.
Property Type | Property Price | Depreciation Period (Years) | Annual Tax Deduction |
---|---|---|---|
Residential Rental Property | $1,000,000 | 27.5 | $36,364 |
This means that every year, you can subtract $36,364 from your W2 taxable income. Which means, that if you made $54,000 dollars this year, and you claim depreciation, you will only be taxed on 17,367 of income.
How do cost segregation studies work?
With depreciation, we look at the building as one entity, and we simply divide the price of the building by either 27.5 or 39. Cost segregation takes depreciation a step further. Instead of treating your whole building as one big item that depreciates over a long time, cost segregation looks at all the different pieces of the building. Here’s how it works:
Break down the building
You look at your property and split it into different parts. For example, carpet and furniture might be considered 5-year property. Electrical systems might be classified as 7-year property and pavements and landscaping could be 15-year property. The building’s structure is still depreciated over 27.5 or 39 years.
Reclassify the parts
Once you’ve broken down the building into different components, you classify them according to how long they typically last (their “useful life”). Remember, this doesn’t mean that you analyze the wear and tear of different components that make up your house. You are merely reclassifying them into what the IRS determines are their “useful lives”.
Accelerate depreciation
By classifying parts of your building into shorter lives, you can depreciate them faster, which means more deductions in the early years of owning the property. Bonus depreciation is another kicker that allows you to accelerate your depreciation even more which we will cover shortly.
Simplified cost segregation example for an Airbnb
Let’s say you own a that you’re renting out on Airbnb. When you think about the building, there are two main parts: the building structure itself (the walls, roof, foundation, etc.) and all the other stuff inside the building, like carpets, lighting fixtures, appliances, and cabinets.
- 20% of the building’s cost ($200,000) is associated with items that can be depreciated over 5 years (e.g., carpets and appliances).
- 10% of the building’s cost ($100,000) is associated with items that can be depreciated over 15 years (e.g., land improvements like sidewalks or landscaping).
- 70% of the building is straight-line depreciation.
Cost segregation allows you to accelerate depreciation deductions by categorizing the building’s components into different asset classes based on their useful lives. Let’s break down the property based on the new total property value of $750,000 below.
Asset Category | Value | Percentage of Building | Annual Depreciation Calculation | Annual Depreciation |
---|---|---|---|---|
5-Year Assets (e.g., Carpets and Appliances) | $150,000 (20% of $750,000) | 20% | $150,000 / 5 | $30,000 |
15-Year Assets (e.g., Land Improvements like Sidewalks or Landscaping) | $75,000 (10% of $750,000) | 10% | $75,000 / 15 | $5,000 |
27.5-Year Assets (Building Structure, Straight-Line Depreciation) | $525,000 (70% of $750,000) | 70% | $525,000 / 27.5 | $19,090.91 |
Total Depreciation | $54,090.91 |
Tax savings straight line depreciation vs. cost segregation
Depreciation Method | Annual Depreciation |
---|---|
Straight-Line Depreciation (27.5 Years) | $27,272.73 |
Cost Segregation | $54,090.91 |
Now, we can see there is a huge difference. In one scenario, we just divide the price of the property by 27.5 years, and that saves us on the one hand, and on the other hand we use a cost segregation study and can save $54,100, which is essentially double.
Bonus depreciation
Bonus depreciation is a tax incentive that lets you deduct a big chunk of your property’s cost in the first year instead of spreading it out over many years. This means you can write off up to 100% of the cost of certain assets, like furniture, appliances, and other equipment used in your rental property, right away. By using bonus depreciation along with cost segregation, you can save even more on your taxes, and bonus depreciation can only be taken advantage of via cost segregation; only depreciation without cost segregation is a no-go.
How can I use these tax savings with cost segregation to my benefit?
You can increase your cash flow immediately
When you use cost segregation and bonus depreciation, you can deduct a large portion of your property’s value in the first year. This means you’ll have a lower taxable income and, therefore, a smaller tax bill. With less money going to taxes, you get to keep more cash in your pocket right away.
Example: Imagine you buy a rental property for $750,000 and use cost segregation to identify $200,000 worth of items that qualify for bonus depreciation. You can write off the entire $200,000 in the first year, which could save you up to $70,000 in taxes (depending on your tax rate). That’s $70,000 more you can reinvest in your property or use for other expenses and future investments!
You can use the tax credit for your future income.
Sometimes, using cost segregation and bonus depreciation can create a “Net Operating Loss” (NOL). This happens when your tax deductions are greater than your income for the year. The good news? You can carry forward this loss to future years, reducing your taxable income down the road. You know how the American media is talking about how billionaires don’t pay any taxes? Many times, it’s because of losses incurred in the past that are carried forward which decreases future tax liability.
Example: Let’s say you generated $100,000 in rental income but took $150,000 in depreciation deductions due to cost segregation and bonus depreciation. This creates a $50,000 net operating loss and you can use this $50,000 loss to offset taxable income in future years. For example, if your net W2 income is $100,000 next year, you can immediately deduct $50,000 from last year’s tax credit.
Lower taxes on property sales
If you decide to sell your property, having used cost segregation and bonus depreciation can reduce the amount of tax you owe on the sale. By depreciating more of the property early on, you reduce its taxable value, which can lower capital gains taxes when you sell.
Example: You purchased a property for $750,000 and have taken significant depreciation deductions over the years. If you sell the property later for $900,000, your taxable gain may be reduced by the amount of depreciation you’ve already claimed. This can result in a much lower tax bill upon selling.
Who benefits from a cost segregation study?
Regular owners of real estate that’s generating cash
Anyone who owns real estate can take advantage of cost segregation, provided they don’t plan to sell the property soon. This strategy isn’t just for landlords or developers—if you own a property and rent it, you can use cost segregation to save money on your taxes. Even better, if you have other investments, like businesses or stocks, you can use the extra depreciation to offset the taxes on those investments as well. If you know about other real estate tax benefits, like the short-term rental tax loophole, then you are familiar with what good tax management can do. Think of cost segregation as a hidden money-saving tool that every property owner has but may not realize is available!
Short-term rentals
Managing short-term rentals like Airbnb or VRBO can be challenging but also highly profitable. For owners of short-term rental properties, accelerating depreciation through cost segregation can significantly boost cash flow. This means more money in your pocket now, which you can use to expand your portfolio and invest in more properties. The increased cash flow from tax savings can help you build a successful and profitable short-term rental business.
FAQ
Can I use cost segregation for a property I already own?
Yes, you can! Cost segregation isn’t just for new property purchases. If you already own a property, you can still perform a cost segregation study and “catch up” on the depreciation you could have taken in previous years. This can lead to significant tax savings now, as the IRS allows you to make an accounting change and claim missed depreciation without amending past tax returns. It’s like finding a hidden treasure chest of tax savings you didn’t know you had!
What types of properties are eligible for cost segregation?
Almost any type of property can benefit from cost segregation, not just commercial buildings or large complexes. This includes residential rental properties, office buildings, retail spaces, warehouses, and even short-term rental properties like those listed on Airbnb. The key is that the property must be income-producing or used for business purposes. So, whether you own a single rental home or a strip mall, cost segregation could provide substantial tax savings.
Do I need to hire a professional for a cost segregation study?
It’s highly recommended. A cost segregation study requires a detailed engineering analysis to break down the property into various components with different depreciation lives. A professional with expertise in both tax law and engineering can ensure that you maximize your deductions while staying within IRS guidelines. Hiring a professional reduces the risk of errors and increases the likelihood that your deductions will stand up to an audit, providing peace of mind along with tax savings.