Cost Segregation Study: How to Take Accelerated Depreciation on Rental Properties

The Big Picture On A Cost Segregation Study:

• • A cost segregation study allows real estate investors to reclassify property components into categories with shorter depreciation periods, enabling accelerated depreciation and reducing taxable income in the early years of ownership.
  • While cost segregation studies can be expensive, typically ranging from $10,000 to $15,000, they can be cost-effective for properties valued over $750,000. For single-family rental properties, services like Rental Property Refund offer studies for around $1,500.
  • By accelerating depreciation, investors can improve cash flow and returns, as the increased deductions reduce tax liability during the initial years of property ownership. This strategy effectively serves as interest-free borrowing from the IRS, as the tax savings can be reinvested or used for property maintenance.

News flash for property owners: things break.

That new roof you’re putting on your rental property? It might keep the elements out now, but give it a few decades, and you’ll need a new one.

That’s why real estate investors can deduct depreciation — the decrease in the value of a building as it ages and approaches the end of its usable life. The U.S. tax code allows you to recover the cost of certain property over the time you use it, providing an allowance for wear and tear, deterioration, or obsolescence.

When you purchase or build real estate, the IRS lets you “deduct” the cost of the building itself. Not all in one year, however: you have to spread the deductions over 27.5 years for residential and 39 years for commercial properties. But we all know many components of a property won’t last anywhere close to three decades. And so does Uncle Sam.

Because of this, real estate investors have a powerful tool to maximize tax benefits and improve cash flow: cost segregation studies.

Cost Segregation Studies Explained

Put simply, a cost segregation study reclassifies as much of a building as possible into other tax categories. Specifically, tax categories that let you depreciate them over shorter periods.

A cost segregation study helps you separate the elements of your property that have different useful lives and, therefore, different depreciation schedules. Instead of the usual 27.5-year depreciation period for the whole property, certain components—such as land improvements or appliances—can be identified and reclassified for faster depreciation.

This lets you deduct more for depreciation in the early years of owning the property. In other words, accelerating the depreciation schedule reduces your taxable income now.

Most real estate syndications use a cost segregation study to accelerate depreciation. One of the many tax advantages that come with them is letting you claim a loss on your tax return even as you collect real cash flow. (And one of the reasons we invest passively in these in our real estate investment club!)

Common Property Components Eligible for Accelerated Depreciation

A thorough cost segregation study often identifies a significant portion of a property’s value as eligible for shorter depreciation periods.

Why Use a Cost Segregation Study?

Although they aren’t cheap, cost segregation studies offer a powerful financial analysis tool for real estate investors looking to loosen Uncle Sam’s grasp. The benefits of cost segregation include improved cash flow, enhanced ROI, and a deeper understanding of your property’s true value and condition.

• • Improved Cash Flow & Returns: Cost segregation studies enable real estate investors to reduce their tax liability in the early years of property ownership. By front-loading rental property tax deductions, investors can reduce their overall tax burden and increase profitability, particularly during the initial years of property ownership before rents have had a chance to rise. This results in improved cash flow that can be reinvested, used for property maintenance, or purchased additional properties.
  • Interest-Free Borrowing from the IRS: When you sell the property, you must repay the IRS for the depreciation tax savings, known as depreciation recapture. But that could be decades from now if you sell at all. In the meantime, you can get an interest-free loan from the IRS.
  • Deeper Understanding of Property Valuation: A cost segregation study provides a detailed breakdown of the property’s components and their respective values. This granular analysis can help determine a more accurate property valuation, which can be an advantage when seeking financing or when making future investment decisions about the property.

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Who Performs a Cost Segregation Study?

Thankfully, you don’t have to do a cost segregation study for those of us who are neither contractors nor tax lawyers. A qualified team of tax and engineering experts comes to inspect your property’s components—assessing everything from the plumbing to the flooring to the landscaping—to determine if you can accelerate the depreciation of any of these items.

This team will identify and segregate various building components into shorter depreciation periods. They’ll even examine architectural plans, engineering specifications, and construction records, looking for opportunities for accelerated property depreciation.

At the end of the study, you’ll receive a detailed report concluding how much you can save on your taxes by using accelerated depreciation. The whole process can take upwards of a month for large apartment complexes, from start to finish.

How Much Do Cost Segregation Studies Cost?

Of course, you’ll pay for these professionals’ time and expertise.

Depending on the size and complexity of your property, you should expect to pay between $10,000 and $15,000 for a commercial cost segregation study and the recommendations in the report. That makes them unfeasibly expensive for most single-family or small multifamily rental properties.

Unless you use a DIY cost segregation study service, that is. Over the last few years, companies like Rental Property Refund have started offering an automated service to provide a lawful cost segregation study based on a quick form that you fill out. It takes minutes instead of a month and costs around $1,500 instead of $5-15K. I’ve also heard positive feedback about KBKG and DIYCostSeg as two additional do-it-yourself options.

Landlords often recoup this one-time cost through tax savings within a few years.

Accelerated Depreciation on a Rental Property

Accelerating depreciation deductions can help commercial property owners realize significant tax benefits in the early years of ownership.

Many types of personal property (think appliances, furniture, and fixtures) depreciate quickly, often over just five or seven years. You can depreciate many land improvements — such as outdoor lighting, paving a driveway or parking lot, or fencing — over 15 years.

Accelerating the depreciation deductions for these components reduces your taxable income, potentially creating substantial tax savings. These savings can improve your cash flow, reduce overall tax liability, and increase your property’s return on investment (ROI).

When Does a Cost Segregation Study Make Sense?

Given their cost, a cost segregation study may not be appropriate for everyone. It would be best to weigh the potential benefits against the study’s significant upfront cost.

A cost segregation study makes great sense in the right situations. Consider a cost segregation study if you meet these conditions:

1. You own a commercial property or multifamily rental property. Large commercial or multifamily residential properties like apartment buildings, which often include a ton of personal property and other depreciable assets, tend to benefit most from a cost segregation study. Properties valued at about $500,000 or more make the best candidates for a worthwhile cost segregation study. And no, you can’t use cost segregation for your primary residence.

2. You have recently purchased, built, or remodeled your investment property. The best time to conduct a cost segregation study is the same year you buy, build, or renovate your investment property. This way, you get the most value from the tax savings from accelerated depreciation. And even if it’s been a few years, you can still do a “look-back” cost segregation study and claim a catch-up tax deduction.

3. You plan to hold the property for at least 3-5 years. It might take you a few years to fully recapture the upfront fees to conduct a cost segregation study, so it only makes sense if you plan to retain the property long enough to reap the tax savings from accelerated depreciation.

When in doubt, consult with your friendly neighborhood tax advisor or a qualified cost segregation specialist to determine the feasibility and potential benefits of a cost segregation study for your specific situation.

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How to Get a Cost Segregation Study

So you’ve decided that a cost segregation study sounds like a good time. Great! Where do you get started?

The process of obtaining a cost segregation study looks like this:

1. Engage a Qualified Professional

You must engage a qualified professional specializing in this field to initiate a cost segregation study. The IRS requires firms to demonstrate engineering, construction, tax law, and accounting expertise to conduct cost segregation studies. Look for providers online or search the American Society of Cost Segregation Professionals website for providers in your state. You’ll then work with that provider to analyze whether your investment property is a good candidate for cost segregation.

2. Gather Relevant Documents

Once you agree to move forward with a cost segregation study, you’ll need to gather records and documents the cost segregation professionals will use to determine the value of your property and its components. At a minimum, plan to provide your most recent appraisal of the property, inspection report results, the closing documents you signed when you bought the property, and any other relevant property records. If you have them, bring any blueprints from when you built or remodeled.

3. Property Review

Over several weeks to a month, the professionals will conduct an extensive review of the property, examining architectural plans, engineering specifications, and construction records. They will identify components that qualify for shorter depreciable lives and classify them based on the applicable tax rules and regulations.

4. Depreciation Reclassification and Cost Allocation Report

Upon completing the component classification, the professional will reclassify the eligible components into shorter depreciation periods and provide a comprehensive cost allocation report. This report details the reclassified components, their values, and the corresponding depreciation periods. It serves as the documentation for the accelerated depreciation you’ll claim on your income taxes.

5. Tax Return Reporting

Armed with the cost allocation report, real estate investors can update their income tax return filings to reflect the accelerated depreciation deductions. It is essential to consult with a tax professional or accountant to ensure compliance with all tax regulations and reporting requirements.

Potential Drawbacks and Risks of Cost Segregation Studies

Cost segregation studies aren’t without their risks. Although they’re perfectly legal and IRS-approved, they do require careful attention to detail and proper documentation.

The IRS Audit Factor

Uncle Sam tends to pay extra attention to accelerated depreciation claims. Why? Because they represent significant tax savings, and the IRS wants to ensure that everything is up and up. Although having a cost segregation study performed by qualified professionals significantly reduces your audit risk, it doesn’t eliminate it entirely. Think of it like wearing a seatbelt while driving — it’s your best protection if something goes wrong.

Documentation Is Your Best Friend

Have you experienced not being able to find your receipt for a business expense? Now multiply that stress by about a thousand. Poor documentation is the fastest way to turn a cost segregation study into a liability. For that matter, you’ll need to maintain detailed records of the study itself, plus supporting documentation for all reclassified components. Keep everything — and I mean everything — from the initial property assessment to the final report.

The Depreciation Recapture Gotcha

Here’s something that catches many investors off guard: when you sell the property, you’ll face depreciation recapture, which is taxed at up to 25%. That’s higher than long-term capital gains rates. If you’ve accelerated depreciation through a cost segregation study, you’re essentially borrowing tax savings from the future. Just make sure you’re prepared for that future bill when it comes due.

FAQs Related To  Cost Segregation Studies

Let’s address some important considerations and common questions that might be on your mind. Like any tax strategy, we must understand the potential pitfalls and practical applications.

Can I Do a Cost Segregation Study on an Older Property?

Yes! It’s called a “look-back” study. The IRS allows you to claim all previously missed depreciation in one lump sum in the current year, making it a powerful catch-up strategy for properties you’ve owned for years.

What’s the Minimum Property Value for a Cost Segregation Study?

Traditional studies make sense for properties valued at $750,000 or more. With newer DIY services costing around $1,500, the minimum drops significantly. Aim for first-year tax savings at least double the study’s cost.

Do I Need to Update My Cost Segregation Study After Renovations?

Any major renovation over $50,000 typically warrants updating your study. New HVAC systems, roof replacements, or complete unit renovations can all be segregated like original property components.

What Happens If I Plan to Hold the Property Forever?

The time value of money makes cost segregation worthwhile even for long-term holds. Today’s tax savings can be reinvested for additional returns, potentially outweighing future depreciation recapture.

Will a Cost Segregation Study Affect My Ability to Get a Loan?

No. It’s purely a tax strategy that doesn’t affect your property’s market value or NOI. The improved cash flow might even make you a more attractive borrower.

What If I Did Major Renovations Before Learning About Cost Segregation?

File Form 3115 (Change in Accounting Method) to claim missed depreciation from prior years. You can potentially take all missed deductions in the current year, but work with a qualified tax professional.

Final Thoughts on What’s a Cost Segregation Study

Cost segregation studies offer a powerful tax strategy to many real estate investors, especially those dealing in commercial real estate or high-value residential rental properties. By reclassifying components of a rental property into shorter depreciation periods, investors can accelerate their depreciation deductions, leading to reduced taxable income, improved cash flow, and potentially significant tax savings.

However, cost segregation studies are no joke. They require significant effort from highly qualified professionals, which means they carry substantial fees. But you get what you pay for; engaging experts experienced in cost segregation ensures accurate component identification, proper classification, and compliance with tax laws and regulations. This is not an exercise in which you want to cut corners.

When done well and in the right situation, a cost segregation study can unlock the full potential of a real estate investor’s rental property, making your investment more rewarding in the long run and freeing up cash in the short term to fund other endeavors.♦

What questions do you still have about how cost segregation studies help real estate investors accelerate depreciation?

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