Remote Cost Seg

How Real Estate Investors Use A Cost Segregation Study

Benjamin Locke

Author

SUMMARY

A cost segregation study helps real estate investors accelerate depreciation on property components, leading to substantial tax savings and increased cash flow. This strategy applies to all property owners, not just large developers, and can significantly reduce taxable income. By leveraging cost segregation, investors can boost their returns and improve their cash flow.

Many real estate investors might have heard the term cost segregation study, and they figure it only applies to real estate developers and individuals or institutions with massive portfolios of assets around the country. Not true! What many don’t know is that cost segregation is a tax loophole that has existed for decades and can be used by anyone, including real estate owners and investors, with only one property in their name. In fact, if you have a property and haven’t yet taken advantage of cost segregation studies, then pause; this could change your entire outlook on depreciation and what you can do with real estate.

What is a cost segregation study?

A cost segregation study is a detailed analysis that identifies and reclassifies personal property assets from real property assets. This reclassification allows for a shorter depreciation life, leading to accelerated depreciation deductions. Essentially, it breaks down a property into its individual components, which can be depreciated over shorter periods compared to the building structure. 

This process results in significant tax savings by maximizing depreciation deductions in the early years of ownership, thereby increasing cash flow and reducing taxable income. In layman’s terms, just like you can depreciate a building over time and save on taxes, with cost segregation, you can separate parts of the property and accelerate that depreciation to save even more; it’s straight-line depreciation vs. accelerated depreciation. If you use this accelerated deprecation method, you will save a ton of money!

 

How do cost segregation studies work?

​​In the eyes of the IRS or any other US tax entity, the depreciation of assets is split into two parts: real property and personal property. In the United States, real property usually takes the form of a 27.5-year lifespan for a residential or multifamily building and 39 years for a commercial building. 

Personal property

Includes items like furniture, equipment, and fixtures that can be moved without causing damage to the building.

Real property

Consists of permanent features such as walls, floors, and plumbing that are integral to the structure and cannot be removed without affecting the building itself.

How does real property vs. personal property differ in terms of depreciation?

Think of depreciation as an estimated life span, the tax authorities are determining how long your assets will survive. In the eyes of the IRS, a building has a lifespan of 27.5 or 39 years, and personal assets such as carpets and furniture have even shorter lifespans in the eyes of US tax authorities, which is a good thing! Below are some examples of common assets that a property might encompass and the different lifespans for each.

Asset Type Years
Carpets 5 years
Computers and peripheral equipment 5 years
Appliances 5 years
Office furniture 7 years
Land improvements (e.g., sidewalks, fencing) 15 years
HVAC systems 27.5 years
Plumbing 27.5 years
Roofing 27.5 years
Building structure (Residential) 27.5 years
Building structure (Multifamily) 27.5 years
Building structure (Commercial) 39 years

These depreciation periods are based on the Modified Accelerated Cost Recovery System (MACRS), which is the primary method used for depreciating property placed in service after 1986. For instance, if you install new land improvements worth $15,000, you can depreciate it over 15 years, resulting in higher initial tax savings compared to the 27.5-year period used for the building structure itself, which uses only straight-line depreciation.

Cross segregation study example: $1 million property using cost segregation studies vs. straight-line depreciation

Let’s take an example of a $1,000,000 property, which is not so uncommon in the US real estate market. In one scenario, we choose to use the classic straight-line depreciation method to calculate what type of tax deduction we can get on a property. In the other scenario, we can look at what a cost segregation study would do to the tax deduction amount.

Without cost segregation (straight-line depreciation)

Component Value Years Equation Annual Depreciation
Total Property Value $1,000,000 27.5 $1,000,000 / 27.5 $36,363.64

Many reading this who are familiar with straight-line depreciation will recognize this formula if they’ve been doing their taxes correctly! Every year, you can deduct $36,364 from your taxes/income generated from your property.

 Now, let’s break down what a cost segregation study would do for the deduction. Here, we will take that same building and divide it into asset classes; 75% of the building will fall into the traditional building structure asset class used for straight line depreciation at 27.5 years, 10% of the building will fall into the 1–15 year asset class and 15% of the building will fall into the 1-5 year asset class.

With cost segregation

Component Value Percentage of Building Equation Annual Depreciation
Total Property Value $1,000,000 100%
27.5-year assets $750,000 75% $750,000 / 27.5 $27,272.73
5-year assets $150,000 15% $150,000 / 5 $30,000
15-year assets $100,000 10% $100,000 / 15 $6,666.67

So, now that we know the asset lifespans, we can calculate how much we can deduct in appreciation on an annual basis using cost segregation.

Year Range Component Annual Depreciation Total
Years 1-5 5-year + 15-year + 27.5-year assets $30,000 + $6,666.67 + $27,272.73 $63,939.40
Years 6-15 15-year + 27.5-year assets $6,666.67 + $27,272.73 $33,939.40
Years 16+ 27.5-year assets $27,272.73 $27,272.73

 

 

Bonus depreciation and cost segregation: The cherry on top

Let’s be clear here: cost segregation saves you money and is a smart move regardless of any extras, but bonus depreciation is by far and away the extra cherry on top! Bonus depreciation allows you to accelerate and claim depreciation for a significant portion of your personal assets, all in year 1! Bonus depreciation has been around for a while in different forms but recently has been tied to the 2017 Tax Cuts and Job Act. Bonus appreciation allows you to frontload depreciation to a certain extent, which leads you to drastically increase your deduction in the first year. The 2017 Tax Cuts and Jobs Act (TCJA) introduced meaningful changes to the tax code, especially regarding tax benefits for real estate investors, and one of the most impactful changes was the introduction of 100% bonus depreciation.

This allowed businesses to immediately deduct the full cost of certain short-lived assets (with useful lives of 20 years or less) in the year they were placed in service. This provision was effective from September 27, 2017, to January 1, 2023. The goal was to incentivize investment by providing substantial upfront tax savings, thereby boosting economic growth and job creation.
However, this 100% bonus depreciation was not permanent. Starting in 2023, the bonus depreciation percentage began to phase out, decreasing by 20 percentage points each year until it fully phases out after 2026. You can see the phase-out schedule here:

2023: 80% bonus depreciation

2024: 60% bonus depreciation

2025: 40% bonus depreciation

2026: 20% bonus depreciation

2027: 0% bonus depreciation

The model below describes what a bonus depreciation deduction would look like for the year 2024, in which an investor is allowed 60% bonus depreciation and claims it in year 1. It’s important to point out that you can ONLY USE BONUS DEPRECIATION WITH COST SEGREGATION. You cannot claim a bonus on the building structure used in straight-line depreciation, as the lifespan must be in the 15-year asset class.

Component Value Bonus Depreciation Calculation Bonus Depreciation
5-year assets $150,000 $150,000 * 60% $90,000
15-year assets $100,000 $100,000 * 60% $60,000
27.5-year assets $750,000 $750,000 / 27.5 $27,272.73
Total YEAR 1 Depreciation $177,272.73

Even though the Tax Cuts and Jobs Act bonus depreciation is phasing out, there is currently legislation making its way through congress to extend bonus depreciation structures similar to what the current status quo is. 

Why do investors need cost segregation studies?

Cost segregation studies significantly reduce your taxable income, and for any investor, this capital can better be employed elsewhere than the US government. For both real estate investors and homeowners, increasing cash flow and making better use of capital is imperative, and particularly in the midst of a high interest rate environment, it is not only attractive but necessary. Furthermore, what many investors don’t realize is that cost segregation studies can offset your taxes in the future for income derived from any source.

Example: $750,000 residential short-term let cash flow using straight-line depreciation vs. cost segregation

For example, let’s say you are using an Airbnb property management company to manage an Airbnb you have in Carbondale, Colorado, that you rent out to skiers and mountain enthusiasts all year round, with a price tag of $750,000. The property will be rented out for a number of years for $60,000 annually with a gross yield of  8%.  After fees, taxes, and interest, you net about $30,000 for an annual net yield of 4%. Let’s take a look at the cash flow with and without cost segregation tax advantages. Below is a breakdown of how you can save money and increase cash flow with cost segregation studies.

Item Straight-Line Depreciation Cost Segregation
Property Price $750,000.00 $750,000.00
Annual Rental Income $60,000.00 $60,000.00
Total Annual Expenses $30,000.00 $30,000.00
Net Income (before depreciation) $30,000.00 $30,000.00
Annual Depreciation Expense $19,230.77 $35,844.23
Net Income After Depreciation $10,769.23 -$5,844.23
Taxable Income (30%) $10,769.23 $0.00
Taxes Due $3,230.77 $0.00
After-Tax Income/Cash Flow $26,769.23 $35,844.23

 

You can increase your cash flow by paying almost no tax in the early years

In real estate investing, cash flow is king, particularly if you are looking to build a real estate portfolio or manage large income-producing assets like multifamily properties. In this model, with cost segregation, an investor can improve cash flow significantly more than if they were to just use straight-line depreciation. You can see in the model above that the person using cost segregation studies pays 0 tax and gives themselves a $5,844 tax credit for next year! 

You can defer taxes on your income for the future 

By accelerating depreciation, property owners can defer taxes and increase cash flow. You might notice how the net cash flow from the cost segregation now significantly exceeds the net rental income. This is because you can carry over depreciation, just like you would a net operating loss in business, and use it for other investments through tax referrals. 

You can increase your ROI significantly. 

Anytime you can save money with taxes, you increase your overall ROI or the return on the equity you invested in the multifamily property. Furthermore, by carrying forward the depreciation into other investments, you can increase your ROI on everything you are investing in down the line. This obviously assumes you will be investing in real estate or other assets in which you can claim important tax credits.

Who uses cost segregation studies?

Regular owners of real estate 

Every living, breathing human being can use a cost segregation if they own a property and are not planning on selling it soon. In fact, real estate owners who have other investments, such as businesses or stocks, can use this accelerated deprecation to offset their taxes on other investments! Think of cost segregation as a money-saving arrow you’ve always had in your quiver as a property owner but just didn’t know it existed. 

Short term rentals 

Short-term rentals like Airbnb can be difficult to manage but extremely lucrative. Therefore, for short-term rental landlords, being able to accelerate depreciation can greatly increase cash-flow, which can greatly improve cash flow and help build an entire portfolio of Airbnbs.

Developers and construction

Cost segregation can significantly improve cash flow by allowing developers and construction professionals to write off their building expenses faster. Instead of waiting for decades to recover their costs through traditional depreciation, they can accelerate the process and see substantial tax savings early on. This means more money in hand to invest in new projects or upgrade existing ones.

Owners of multifamily buildings or commercial buildings

Owners of multifamily buildings benefit from cost segregation by reducing taxable income in the early years of ownership. This strategy frees up capital for property improvements, increasing the building’s overall value and appeal.

How do I do a cost segregation study?

Some companies want you to make several phone calls, provide useless documents, and charge a ton of money for questionable “professionals” like niche engineers. However, because we at Remotecostseg are investors ourselves, we have made it into an easy 3-step process:

Step 1: Initial consultation for cost segregation and feasibility analysis

Schedule a private, one-on-one consultation with an expert Cost Segregation Advisor. During this session, they can review your investment situation to see if you and your property qualify for the benefits of a cost segregation study and estimate how much you can save in taxes. 

Step 2: Zoom call and data extraction 

Once the study is commissioned, you’ll have an onboarding call with your Account Manager. During this call, they’ll gather all the remaining details and relevant documents about your property. The aim is to collect everything needed during this call, so there are no follow-up emails or extra tasks for you. After the call, they’ll start working on your study right away.

Step 3: Final call and report delivery

Once your report is ready, they will schedule a quick 15-minute call to go over your study. During this call, they will explain your final numbers and, most importantly, your tax savings. They will also answer any questions you have and then deliver your report, and your real estate CPA is more than welcome to join. 

FAQ

How much does a cost segregation study cost? 

Beware of DIY Cost Segregation Studies! The cost of a cost segregation study done by a professional typically ranges from $5,000 to $15,000, depending on the property’s size and complexity.  Larger or more intricate properties may incur higher costs, sometimes exceeding $20,000. These studies involve detailed analysis by professionals to maximize tax benefits through accelerated depreciation which saves you money! 

When can you do a cost segregation study?

You can perform a cost segregation study any time after you buy, build, or remodel a property. The best time to conduct the study is before you file your tax return for the year in which the property was acquired or improved. This timing allows you to maximize tax savings by accelerating depreciation deductions as soon as possible.

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Save $40,353 In Taxes This Year With A Cost Segregation Study

Our average client saves $40,353 in taxes their first year at a 12.1x ROI after investing in a cost segregation study. Will you be next?

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