Cost segregation on a rental property: What it is and how it works

Cost segregation on rental properties has been a powerful strategy used by real estate investors to grow their wealth for decades. This is evident when looking at the tax returns of real estate investors who pay very little to no tax despite their tremendous wealth. As a result, many people think that this tax-deferring strategy is a form of tax avoidance available only to the rich. 

This is simply untrue. Believe it or not, this strategy is available to everyone who owns a property and has the know-how to implement it.

In this article, we’ll talk about the meaning of cost segregation and how you can use it to your advantage. We’ll also look at examples of what it can do to your cash flow and the pros and cons of doing cost segregation on your rental property. 

Keep in mind, this article is not legal or tax advice and it’s recommended that you perform your own research before making any decisions about Cost Segregation. We use examples here to illustrate our understanding of the tax rules. Talk to your tax accountant and attorney to learn more.

What is cost segregation on rental property?

Cost segregation is a tax-deferring strategy used by real estate investors to accelerate the depreciation of their property on paper. This allows them to also accelerate their depreciation expenses which they can use in filing tax returns to write off or reduce their tax liabilities. 

A rental property is usually composed of the land and the building. The IRS allows you to depreciate the building over the course of 27.5 years. For example, by the rules of this IRS, if the building on your property is valued at $800,000, you can write off $29,090 per year as a depreciation expense from your taxable income over the course of 27.5 years.

That’s great. However, it’s estimated that 20-40% of the building’s components depreciate quicker. Examples of these are fences, electrical wiring, walkways, flooring, roofs, furniture, and appliances.

What cost segregation does is it accelerates the depreciation of those components into 5, 7, and 15-year intervals. To do this, cost segregation firms composed of engineers and/or accountants perform an engineering-driven study to segregate the property into 4 components: 

• Land
• Building
• Land improvements (walkway, fence, flooring, etc.)
• Personal property (washing machine, dryer, furniture, heater, etc.)

While the building structure itself will still depreciate in 27.5 years, the land improvements, personal property, and other components that can be reclassified in the study will depreciate sooner. 

How cost segregation works

Imagine you bought a 4-unit apartment valued at $1,000,000. Let’s say the building is worth $800,000. If you did not do a cost segregation study, you can write off $29,090 per year as discussed earlier. 

But, if you hired a cost segregation firm and it determined that about 30% of the property depreciates in around 5 years, you can write off $60,000 annually from your taxable income for the next 5 years. 

Based on $1M property using Cost Segregation rules set by the IRS[/caption] Based on $1M property using Cost Segregation rules set by the IRS

It gets better, the Tax Cuts and Jobs Act of 2017 allows you to use 100% bonus depreciation on qualified properties. What this means is you are allowed to take the accelerated depreciation expense determined by the cost segregation study in year one. To make this clearer, let’s look at the example used earlier. 

If the cost segregation firm sees that 30% of your property depreciates in 5 years, that amounts to $300,000 which works out to $60,000 annually. But because of the bonus depreciation covered in the Tax Cuts and Jobs Act of 2017, you are allowed to take that $300,000 tax write-off in the first year. 

This increases your cash flow significantly allowing you to use the money to reinvest in your property which increases its value or acquire another to further increase your cash flow. The bottom line is that doing a cost segregation study on your property lets you legally wipe off or reduce your income tax liability early in your rental property investment journey. 

Keep in mind, however, that the bonus depreciation will start to fizzle out by 20% each year starting January 1 of the following year. So instead of 100% bonus deprecation, it becomes 80% by year 2, 60% by year 3, and so on until it no longer exists. 

What a cost segregation study isn’t

Contrary to common belief, using a cost segregation study isn’t tax avoidance. The IRS fully recognizes a cost segregation study and has even provided guidelines on how to use it. 

Having a cost segregation study doesn’t mean you don’t have to pay your taxes. Instead, you are only deferring your taxes to when you sell your property. This is called depreciation recapture. When you sell your property at a gain, you will have to treat all or part of the gain as ordinary income. 

That means the new baseline for calculating your taxes is your capital gain and the depreciated value of the property. To understand this concept better, let’s look at a simplified scenario. 

Scenario: 

You bought a 4-unit apartment for $1,000,000 and you hired a firm to do a cost segregation study. They found that 30% or $300,000 worth of your property can be depreciated within 5 years. So now you took advantage of the bonus depreciation and were able to write off all your income taxes in the first year. 

Five years later you decided to sell the property at $2,000,000. Normally, you will be taxed on the $1,000,000 you gained. But because you did a cost segregation study and depreciated 30% of the property’s value sooner, you now have to pay taxes on the $1,000,000 capital gain plus the $300,000 you’ve depreciated. In that sense, the depreciation expense you used to reduce your tax liabilities early on has been recaptured. 

Benefits of doing a cost segregation study on a rental property

Immediate access to significant amount of cash

One of the primary reasons investors use this strategy is the significant access to cash. By using the depreciation expense to write off your taxable income, you will be able to use the cash (that should’ve been paid to the IRS) to invest in other properties and increase your cash flow. 

Furthermore, the value of the US dollar will depreciate over 27.5 years because of inflation. Thus many investors believe taking advantage of the cost segregation study is a good wealth-building strategy. 

May reduce insurance premiums

When you have detailed reporting on every component of the building, you can substantiate every replacement cost to the insurance provider. Because of that, the underwriter can make a more informed decision in assessing the risk on your property. 

Furthermore, having a thorough report on your property helps support claims you make in your favor. The detailed reporting on the different components of the building serves as a document you can use to justify your expenses when replacing a building component.

It gives you tax benefits

You can use your depreciation expense to write off or reduce any taxable income from your rental property. For Real Estate Professionals (REP), you can even use that depreciation expense to offset your personal income. 

Furthermore, you can roll over the remaining amount of your depreciation expense to write off or reduce your taxable income for the following years. 

Needless to say, a cost segregation study is more appealing for real estate professionals but still provides powerful tax advantages to those who aren’t. 

Drawbacks of doing cost segregation on a rental property

It’s Expensive

A quality cost segregation study needs to be performed by a qualified individual with expertise and experience, usually, an engineer belonging to a cost segregation firm, that is why performing such a study will incur a steep upfront cost. 

The cost of hiring a firm that can perform a cost segregation study on your rental property typically ranges from $5,000 to $15,000. This depends on several factors such as the size of the property, type of building, and other physical characteristics. 

You’ll pay for depreciation recapture when you sell

Although you might have had some tax advantages in the beginning, you’ll eventually have to pay your gain once you sell your property. And if you weren’t careful in using the money you saved from your tax write-off, this could easily eat away your profit. 

Long-time real estate investors recommend using the money to expand your real estate. Some of the ways you can do that are by buying a new rental property or reinvesting it in your property to increase its value. 

Negligence penalty for aggressive cost segregation studies

Even if you’re not the one who conducted the study, you are subject to a negligence penalty of 20% of the underpayment in tax if the IRS identifies an aggressive position taken in a cost segregation study. 

This is often a case of not hiring a firm with expertise and experience in performing such a study. 

Tax benefit limit for non-real estate professionals

As discussed earlier, there are certain restrictions on how non-real estate professionals can use a cost segregation study. One of those is that they can only use it to write off taxable income from their rental property. So you need to have an occupied, cash-flowing investment property in order to qualify for the study.

Additionally, there’s a limit to how much depreciation you can use to write off their income in the first year. Real estate professionals can use bonus depreciation to get their tax benefits in the first year while non-professionals might have to wait for several years to get the same amount of tax benefit.