The Best Kept Secret in Real Estate Tax Savings
Real estate investing comes with major tax benefits, and one of the most beneficial is depreciation. What if, instead of waiting 27.5 or 39 years to take full advantage of depreciation, you could take the majority of that depreciation benefit in year one?? With cost segregation, you can.
This powerful tax strategy allows you to accelerate the depreciation of your investment property, resulting in substantial tax savings and improved cash flow. As an individual investor, cost segregation can be a game-changer for your portfolio.
This comprehensive guide breaks down exactly what a cost segregation study is, how the process works, who can benefit from them the MOST, and key factors to consider before getting a cost segregation study.
Key Takeaways:
- Cost segregation accelerates depreciation, leading to significant tax savings for real estate investors.
- Remote studies can be completed in as little as 6 weeks, avoiding lengthy on-site processes.
- Engineered studies offer the highest tax savings and IRS compliance.
- Ideal for residential rentals and commercial properties acquired in the last 5 years or after major renovations.
- Choosing the right provider ensures maximum benefits and long-term audit support.
What is a Cost Segregation Study?
Cost segregation is a strategic tax planning method that allows you to accelerate depreciation deductions on your investment real estate assets. In plain English, it’s a process by which you take an investment property like an AirBnB rental, a condo, or a commercial property(viewed as a single, “lump sum” asset by the IRS) and break it down into its individual component parts (such as windows, doors, HVAC systems, cabinets, etc.). These components have unique depreciation schedules, enabling you as an investor to accelerate much of the depreciation faster than the standard 27.5-year” lump sum” timeline for residential properties or 39-year timeline for commercial properties. It works by identifying personal property assets that are grouped with real property in your buildings. This includes items like wiring, lighting, plumbing, appliances, fences, flooring, and more. By separating out these personal property assets, you can depreciate them over 5, 7, or 15 years rather than the longer standard timelines for real estate. For qualified individuals, this accelerated depreciation directly reduces your taxable income, with a particular focus on generating substantial first-year savings.
Two Ways to Conduct a Cost Segregation Study
When it comes to cost segregation studies, it’s crucial to understand the different methods available. Each approach has its own merits and drawbacks, and choosing the right one can significantly impact your tax savings and most importantly, audit risky. Let’s break down these approaches:
1. “Rule of Thumb” Method
- Essentially a glorified spreadsheet with static formulas
- Assigns fixed percentages to various components of a property (e.g., roofs are 2% of purchase price, cabinets are 0.5% of purchase price)
- Not accepted by the IRS as a legitimate way to conduct a study
- We strongly advise against using this method to ensure compliance with IRS guidelines and and maximize your benefits
Pro’s: Study can be conducted in as little as 5 minutes. Online studies using the Rule of Thumb approach can typically be purchased for less than $1,000 Cons: Not accepted by the IRS as a legitimate way to conduct a study. Risk of penalties and fines in the event of an audit. Typically much lower overall accelerated depreciation benefit due to generic formulas being applied. While the Rule of Thumb method might seem appealing due to its simplicity, it’s important to note that it lacks the precision and detail required for an IRS-compliant cost segregation study. This approach can lead to inaccurate depreciation calculations and potentially raise red flags during an audit. As a result, it’s generally not recommended for serious real estate investors looking to optimize their tax strategy.
2. Engineered Study
This is the IRS-approved approach to cost segregation, which can be further divided into two sub-categories:
2a. Residual Estimate Approach
- Approved by the IRS
- Analyzes about 65% of the property
- On average, results in 55% less depreciation benefits compared to the “Cost Engineered Estimate” approach below
- Quicker to complete and cheaper on the front end
- Suitable for investors looking for a balance between speed, cost, and benefits
The Residual Estimate Approach offers a good middle ground for many investors. It provides a significant portion of the potential tax benefits while keeping costs and time investment in terms of study fulfillment relatively low. This method is particularly useful for those who want to start realizing tax savings quickly or have budget constraints. However, it’s important to note that this approach may leave some potential savings on the table.
2b. Cost-Engineered Estimate Approach
- Considered the gold standard by the IRS
- Analyzes 100% of the property
- Takes 40-60% longer to conduct (and as a result, is more expensive on the front end)
- Guarantees maximum deductions with most accuracy
- Ideal for investors prioritizing the highest possible tax savings
The Cost Engineered Estimate Approach is the most thorough and comprehensive method available. Analyzing every aspect of the property ensures that no potential tax savings are overlooked. While it requires a larger upfront investment in time and money, it often pays for itself many times over through maximized depreciation deductions. This method is particularly beneficial for high-value properties.
How Does the Cost Segregation Process Work?
A cost segregation study, a detailed engineering-based analysis of your property’s components, is performed to identify opportunities for accelerated depreciation on your properties. The study is conducted by experts in engineering, tax law, and cost segregation. They follow a systematic process to maximize your savings while ensuring compliance with IRS guidelines. Here are the main steps:
Property Analysis
The cost segregation firm will assess your property remotely to determine the potential opportunities available. This includes feasibility based on property type, age, location, and value.
Detailed Engineering Study
Your property is examined through a thorough review of building plans and documentation. Every component is identified and categorized based on tax rules for depreciation schedules.
Asset Classification
Your assets are further classified into proper IRS categories and recovery periods. The goal is maximizing accelerated depreciation within the regulations.
Preparation of Report
You receive a comprehensive report documenting the opportunities for accelerated depreciation in your property. This includes reclassified assets, their new depreciation schedules, and the total amount in taxes you’d be saving on your property.
Tax Return Filing
You provide the report to your CPA to reflect the newly allocated depreciation when filing your taxes. The accelerated schedules directly reduce your taxable income.
The entire process is completed within 6-8 weeks. You can conveniently provide property details and records as an individual investor. There’s no need for complex logistics or on-site visits.
The streamlined, virtual process makes cost segregation simple to put into action for your portfolio.
Cost Segregation Study Example
For a single-family home utilized as a short-term rental, a cost segregation study would involve:
- A review of closing statements, improvements records, and any appraisals, blueprints, and other specifications of the home
- An In-depth, room-by-room analysis of all interior and exterior elements of the home
- Analyzing the construction costs (if applicable) and improvement/repair records.
- Categorizing components like wiring, plumbing, roofing, HVAC systems, flooring, fences, security systems, etc. into appropriate IRS property classes and recovery periods.
- Preparing a report detailing the cost and accelerated depreciation opportunities for each component.
What Types of Properties Benefit Most?
If you own any of these types of investment real estate, you’re likely a strong candidate for a cost segregation study:
- Residential rental properties – single family rentals, apartments, vacation rentals etc.
- Commercial real estate – office buildings, retail centers, warehouses
- Hotels/motels
- Medical offices
- Industrial facilities
You’ll benefit the most from conducting a cost segregation study if:
- You’ve acquired the property within the last 5 years
- You have not done cost segregation previously on the property
There is a common misconception that only multi-million dollar commercial facilities benefit from a cost segregation study. This could not be further from the truth! While many CPAs / cost engineering firms are only interested in doing large multi-million dollar commercial facilities, a cost segregation study on a single family home will on average save the investor $40,353 in year 1 tax savings, at an average 10.1x ROI on the cost of the study itself.
What Are the Benefits of Cost Segregation for Investors?
The benefits of cost segregation for real estate investors include:
- Increased Depreciation Deductions – The main benefit is taking larger depreciation write-offs in the early years of ownership, directly reducing taxable income.
- Improved Cash Flow—The tax savings generated can then be reinvested into your business for growth, fueling further real estate investments.
- High ROI – Most cost segregation studies yield a 10x+ tax-savings ROI above their cost in the first year alone.
- Compliance – Reputable firms that follow IRS-approved processes ensures your study is compliant, reducing the risk of an audit and penalties
- Audit Support – All cost segregation support or documentation requested by the IRS will be covered by the firm, providing peace of mind. Additionally, at Remote Cost Seg any penalties or fees incurred as a result of an error in the cost segregation study will be covered by the firm.
- Time Savings – The streamlined virtual process minimizes time spent on logistics and meetings.
For most individual real estate investors, the substantial tax rewards outweigh the upfront costs and time commitment required. Cost segregation can be a real game-changer.
How Long Does the Cost Segregation Process Take?
Traditional cost segregation studies can take anywhere from 3-6 months to complete. They require extensive on-site visits, complex logistics, and back-and-forth communication. However, at Remote Cost Seg, our streamlined virtual process saves you substantial time. Our studies are completed in just 6 weeks from start to finish (rush orders are available with as little as one week turnaround), with only a few hours of your time required.
- Here’s how we accelerate the timeline:
- Virtual Process – No need for on-site visits, minimizing logistical delays.
- Technology – Our proprietary software expedites engineering analysis.
- Specialization – Our sole focus on cost segregation improves efficiency.
- Multi-layer review – Every study we complete is thoroughly inspected by a minimum of one engineer, a senior engineer, and a CPA – ensuring no deduction is left unturned
- Communication – Our team is highly responsive and transparent.
- Experience – Our extensive experience improves speed.
Our faster timeline means you can start generating tax savings even quicker. We understand time is money in the world of real estate investing.
When Should You Consider a Cost Segregation Study?
To maximize benefits, the optimal times to perform a cost segregation study include:
- Immediately after acquiring a new property
- For existing properties that have not had a study previously
- After completing major renovations or improvements
In short, the sooner you perform cost segregation, the quicker you can start generating major tax savings.
What Should You Look for in a Cost Segregation Provider?
As with most tax and financial strategies, expertise is critical to maximize benefits while minimizing risks. Here are the key traits to seek out in choosing a cost segregation provider as an individual real estate investor:
- Niche Expertise in Cost Segregation – A provider dedicated solely to cost segregation with seasoned engineering, tax, and real estate teams.
- Proven Track Record – A history of successful studies across a range of individual investor clients and property types. You can take a look at what our clients have to say about working with us here.
- Efficiency – Ability to complete studies quickly and virtually to minimize time spent.
- Clear Communication – Able to explain even the most complex tax concepts in simple, understandable terms.
- Responsiveness – able to quickly and easily get ahold of a (real!) human to have your questions answered
- Guaranteed Results – Some firms guarantee a minimum 5x ROI or will refund your investment. This provides assurance upfront.
- Ongoing Support – Assistance reinvesting tax savings and planning next steps for your portfolio. Look for a true partner.
- Virtual Capabilities – Offer remote studies for added convenience as an individual investor.
The right partner can make a significant difference in the outcome of your cost segregation study and overall experience.
Are You Ready to Unlock Major Tax Savings?
With the proper planning and expertise, cost segregation provides immense tax advantages for individual real estate investors. Accelerated depreciation directly benefits your bottom line. While there is an upfront time and money investment, the long-term payoff is substantial for most real estate investors – often yielding a 5-10x ROI. You now have a solid foundation to evaluate whether cost segregation could be a game-changer for your portfolio. Contact Remote Cost Seg for a free property assessment and savings estimate. Our experts can map out your unique scenario. Every day counts when it comes to generating tax savings. So don’t leave money on the table. Discover today if cost segregation is right for your next investment property!
Frequently Asked Questions
What is cost segregation?
Cost segregation is a tax planning strategy that allows you to accelerate depreciation deductions on investment real estate. It involves segregating personal property assets from real property assets for faster depreciation.
How does cost segregation work?
Cost segregation firms use engineering and tax analysis to identify property components that can be depreciated over 5-15 years rather than 27.5 or39 years. This acceleration generates increased depreciation deductions and tax savings.
What properties qualify for cost segregation?
Commercial real estate, residential rentals, hotels, medical offices, and industrial facilities qualify. The property must be used for business or investment, not as a primary residence.
What are the main benefits of cost segregation?
The main benefits are increased depreciation deductions in early years, improved cash flow from tax savings, and higher ROI compared to the upfront study cost.
Does cost segregation involve “recapturing” depreciation later?
When you sell the property, you may owe depreciation recapture taxes on the previously deducted depreciation. These taxes will be calculated based on the gain on sale.
How much does a cost segregation study cost?
Costs vary based on the property value, size, complexity, and provider. Typically $5,000 – $15,000. The tax savings outweigh the cost for most investors.
How can I find the best cost segregation company?
Look for expertise in engineering, tax law, and cost segregation specifically. Verify their track record of successful studies. Reviews and case studies are telling.
