Cost Segregation Real Estate: A Tax Strategy for Investors

Real estate investing can be a lucrative way to generate passive income and build wealth. However, it also comes with some challenges, such as managing properties, finding tenants, and paying taxes. Fortunately, there is a tax strategy that can help real estate investors save money and increase their cash flow: cost segregation.

Cost segregation is a method of accelerating the depreciation of certain components of a property, such as the land, building, and personal property. By doing this, investors can reduce their taxable income and pay less taxes in the present, while deferring taxes to the future. Cost segregation can also increase the return on investment (ROI) and the net present value (NPV) of a property.

In this article, we will explain what cost segregation is, how it works, and what are the benefits and drawbacks of using this strategy. We will also provide some examples, calculators, and tips to help you decide if cost segregation is right for you. Let’s get started!

What is cost segregation real estate?

Cost segregation is a tax strategy that allows real estate investors to separate the various components of a property into different categories based on their useful life and depreciation rate. By doing this, investors can allocate more of the property’s cost to shorter-lived assets that can be depreciated faster, such as personal property and land improvements.

Typically, when you buy or build a property, you have to depreciate the entire cost of the property over 27.5 years for residential properties or 39 years for commercial properties. This means that you can deduct a small percentage of the property’s cost each year as an expense against your rental income.

However, with cost segregation, you can identify and reclassify some of the property’s components as personal property or land improvements that have shorter useful lives of 5, 7, or 15 years. This means that you can deduct a larger percentage of the property’s cost each year as an expense against your rental income.

For example, suppose you buy a residential property for $500,000. Without cost segregation, you would have to depreciate the entire amount over 27.5 years, which means that you can deduct about $18,182 per year ($500,000 / 27.5) as an expense.

However, with cost segregation, you can separate the property into four categories: land, building, personal property, and land improvements. Suppose that after a cost segregation study, you find out that the land is worth $100,000, the building is worth $300,000, the personal property is worth $50,000, and the land improvements are worth $50,000. In this case, you can depreciate each category as follows:

• Land: You cannot depreciate land because it does not wear out or lose value over time.
• Building: You can depreciate the building over 27.5 years as usual, which means that you can deduct about $10,909 per year ($300,000 / 27.5) as an expense.
• Personal property: You can depreciate the personal property over 5 years, which means that you can deduct about $10,000 per year ($50,000 / 5) as an expense. Personal property includes items such as furniture, appliances, carpeting, blinds, and fixtures.
• Land improvements: You can depreciate the land improvements over 15 years, which means that you can deduct about $3,333 per year ($50,000 / 15) as an expense. Land improvements include items such as landscaping, fencing, paving, and drainage systems.

As you can see, with cost segregation, you can deduct a total of $24,242 per year ($10,909 + $10,000 + $3,333) as an expense, which is much higher than the $18,182 per year without cost segregation. This means that you can reduce your taxable income and pay less taxes in the present, while deferring taxes to the future.

How does cost segregation work?

Cost segregation is not a simple process that you can do by yourself. It requires a professional who has the expertise and experience to perform a detailed analysis of your property and its components. This professional is called a cost segregation specialist or engineer.

A cost segregation specialist will conduct a cost segregation study, which is a comprehensive report that identifies and documents the various components of your property and their respective depreciation rates. The cost segregation study will also provide the supporting evidence and documentation that you need to justify your depreciation deductions to the IRS.

A cost segregation study typically involves the following steps:

1. The cost segregation specialist will visit your property and inspect its physical condition and features. They will also take measurements and photographs of the property and its components.
2. The cost segregation specialist will review the purchase or construction documents of your property, such as invoices, contracts, blueprints, and appraisals. They will also gather information about the history and use of the property.
3. The cost segregation specialist will classify each component of your property into one of four categories: land, building, personal property, or land improvements. They will also assign a useful life and a depreciation method to each component based on the IRS guidelines and regulations.
4. The cost segregation specialist will allocate the cost of your property to each component based on their fair market value or engineering estimates. They will also calculate the depreciation deductions for each component for each year of ownership.
5. The cost segregation specialist will prepare a detailed report that summarizes the findings and conclusions of the cost segregation study. The report will include a breakdown of the property’s components, their costs, their useful lives, their depreciation methods, and their depreciation deductions. The report will also include supporting documents such as photographs, diagrams, tables, charts, and references.

A cost segregation study can take several weeks or months to complete depending on the size and complexity of your property. The cost of a cost segregation study can vary depending on the scope and quality of the service. However, it is generally estimated that a cost segregation study can cost between $5,000 and $15,000 per property.

What are the benefits of cost segregation?

Cost segregation can provide several benefits for real estate investors who want to save money and increase their cash flow. Some of the main benefits are:

• Reduced taxable income: By accelerating the depreciation of your property’s components, you can reduce your taxable income in the present and pay less taxes in the current year. This can help you offset your rental income or other income sources and lower your tax bracket.
• Increased cash flow: By paying less taxes in the present, you can increase your cash flow and have more money available for reinvesting in your business or personal needs. You can also use the extra cash flow to pay off your mortgage faster or fund other expenses.
• Increased return on investment: By reducing your taxable income and increasing your cash flow, you can increase your return on investment (ROI) and net present value (NPV) of your property. ROI measures how much profit you make from your investment relative to its cost. NPV measures how much your investment is worth in today’s dollars after accounting for future cash flows and discount rates.
• Deferred taxes: By accelerating the depreciation of your property’s components, you can defer the taxes that you would otherwise pay in the future. This means that you can postpone paying taxes until you sell the property or until the depreciation deductions run out. This can help you avoid paying taxes at a higher rate in the future or take advantage of tax rate changes.
• Increased tax deductions: By accelerating the depreciation of your property’s components, you can increase your tax deductions in the present and take advantage of other tax benefits. For example, you can use the bonus depreciation or the section 179 deduction to deduct 100% of the cost of certain qualified property in the year of purchase. You can also use the passive activity loss rules to offset your passive income from other sources with your passive losses from your rental property.

As you can see, cost segregation can be a powerful tax strategy for real estate investors who want to save money and increase their cash flow. However, cost segregation is not without its drawbacks and limitations. Let’s take a look at some of them.

What are the drawbacks of cost segregation?

Cost segregation is not a perfect solution for every real estate investor. It has some drawbacks and limitations that you should be aware of before using this strategy. Some of the main drawbacks are:

• Increased audit risk: By accelerating the depreciation of your property’s components, you may increase your audit risk with the IRS. The IRS may question the validity and accuracy of your cost segregation study and challenge your depreciation deductions. Therefore, you need to make sure that your cost segregation study is done by a qualified and reputable professional who can provide adequate documentation and support for your claims.
• Increased recapture tax: By accelerating the depreciation of your property’s components, you may increase your recapture tax when you sell the property. Recapture tax is the tax that you have to pay on the depreciation that you deducted in the past. The recapture tax rate is usually 25% for real estate property. Therefore, you need to factor in the recapture tax when you calculate your net profit from selling the property.
• Decreased basis: By accelerating the depreciation of your property’s components, you may decrease your basis in the property. Basis is the amount that you paid for the property plus any improvements that you made minus any depreciation that you deducted. Basis affects how much capital gain or loss that you have to report when you sell the property. Therefore, by decreasing your basis, you may increase your capital gain or decrease your capital loss when you sell the property.
• Limited applicability: Cost segregation is not applicable to every type of property or every type of investor. Cost segregation is mainly beneficial for properties that have a lot of personal property or land improvements that can be depreciated faster than the building. Cost segregation is also mainly beneficial for investors who are in a high tax bracket and have a lot of taxable income to offset with depreciation deductions. Therefore, you need to evaluate your situation and goals before using cost segregation.

As you can see, cost segregation has some drawbacks and limitations that you should consider before using this strategy. You should weigh the pros and cons of cost segregation and compare it with other tax strategies to find out what works best for you.

How to do cost segregation real estate?

If you want to do cost segregation for your real estate property, you need to follow these steps:

1. Find out if you qualify for cost segregation: Cost segregation is not for everyone. You need to meet certain criteria to be eligible for cost segregation. Some of the criteria are:
• You own or built a property after 1986.
• Your property is used for business or income-producing purposes.
• Your property has a depreciable life of more than 20 years.
• Your property has components that can be depreciated faster than the building.
• You plan to hold the property for at least five years.
• You are in a high tax bracket and have a lot of taxable income to offset with depreciation deductions.
2. Hire a cost segregation specialist: Cost segregation is not a DIY project. You need to hire a professional who has the expertise and experience to perform a cost segregation study for your property. You should look for a cost segregation specialist who has:
• A background in engineering, accounting, or construction.
• A certification or accreditation from a reputable organization such as the American Society of Cost Segregation Professionals (ASCSP) or the National Association of Cost Segregation Specialists (NACSS).
• A portfolio of previous cost segregation studies that they have done for similar properties.
• A good reputation and references from previous clients.

Provide information and documents to the cost segregation specialist: You need to provide relevant information and documents tosegregation for your real estate property and enjoy its benefits. However, you should also be aware of some frequently asked questions and answers that can help you understand cost segregation better.

What are some frequently asked questions and answers about cost segregation?

Cost segregation is a complex and technical topic that may raise some questions and doubts in your mind. Here are some of the most frequently asked questions and answers about cost segregation that can help you clear your confusion and learn more about this strategy.

Q: Do I need to get an IRS approval to do cost segregation?

A: No, you do not need to get an IRS approval to do cost segregation. You can do cost segregation for your property as long as you meet the eligibility criteria and follow the IRS guidelines and regulations. However, you need to make sure that your cost segregation study is done by a qualified and reputable professional who can provide adequate documentation and support for your depreciation deductions. You also need to be prepared to defend your cost segregation study in case of an IRS audit.

Q: How do I find a good cost segregation specialist?

A: You can find a good cost segregation specialist by doing some research and asking for referrals. You should look for a cost segregation specialist who has a background in engineering, accounting, or construction, a certification or accreditation from a reputable organization, a portfolio of previous cost segregation studies, and a good reputation and references from previous clients. You should also compare the fees and services of different cost segregation specialists and choose the one that suits your budget and needs.

Q: How much does a cost segregation study cost?

A: The cost of a cost segregation study depends on the size and complexity of your property and the scope and quality of the service. However, it is generally estimated that a cost segregation study can cost between $5,000 and $15,000 per property. You should consider the cost of a cost segregation study as an investment that can pay off in the long run by saving you money and increasing your cash flow.

Q: How long does a cost segregation study take?

A: The time required for a cost segregation study depends on the availability and cooperation of the parties involved and the amount of information and documents required. However, it is generally estimated that a cost segregation study can take several weeks or months to complete depending on the size and complexity of your property.

Q: Can I do cost segregation for an existing property that I have owned for several years?

A: Yes, you can do cost segregation for an existing property that you have owned for several years. However, you need to file an IRS Form 3115 (Application for Change in Accounting Method) to report the change in your depreciation method. You also need to calculate the catch-up depreciation, which is the difference between the depreciation that you have claimed in the past and the depreciation that you should have claimed with cost segregation. You can deduct the catch-up depreciation in one year without paying any interest or penalties.

Q: Can I do cost segregation for a property that I plan to sell soon?

A: Yes, you can do cost segregation for a property that you plan to sell soon. However, you need to consider the impact of cost segregation on your recapture tax, basis, and capital gain or loss when you sell the property. You may end up paying more taxes or making less profit from selling the property if you do cost segregation too close to the sale date.

Conclusion

Cost segregation is a tax strategy that allows real estate investors to accelerate the depreciation of certain components of their property, such as personal property and land improvements. By doing this, investors can reduce their taxable income and pay less taxes in the present, while deferring taxes to the future. Cost segregation can also increase the cash flow, return on investment, and net present value of their property.

However, cost segregation is not a simple or easy process that anyone can do by themselves. It requires a professional who can perform a detailed analysis of their property and its components and provide a comprehensive report that supports their depreciation deductions. It also involves some drawbacks and limitations that investors should be aware of before using this strategy.

If you are interested in doing cost segregation for your real estate property, you should consult with a qualified and reputable cost segregation specialist who can help you with the process and the filing. You should also evaluate your situation and goals and weigh the pros and cons of cost segregation to find out if it is right for you.

We hope that this article has helped you understand what cost segregation is, how it works, and what are the benefits and drawbacks of using this strategy. If you have any questions or comments, please feel free to contact us. Thank you for reading!

Table

Component	Useful life	Depreciation method	Example items
Land	Not depreciable	N/A	The ground on which the property is built.
Building	27.5 years for residential properties or 39 years for commercial properties	Straight-line method	The structure of the property, such as the walls, roof, floors, doors, windows, plumbing, wiring, etc.
Personal property	5 or 7 years	Double-declining balance method or 200% declining balance method	The movable items within the property, such as furniture, appliances, carpeting, blinds, fixtures, etc.
Land improvements	15 years	Straight-line method or 150% declining balance method	The items that enhance the land outside the property, such as landscaping, fencing, paving, drainage systems, etc.