Updated June 25, 2020
“Time is money!” We’ve all heard this saying, and it could not be more true than when you’re talking about using cost segregation for your residential real estate investments. You might know how depreciation works, but many investors are not familiar with cost segregation and those who have heard of cost segregation may have some incorrect assumptions about it.
In sum, cost segregation is a depreciation strategy. It allows you to classify your real estate assets is such a way that you can benefit from accelerated depreciation (depreciating assets for five, seven or 15 years instead of 27.5 years for residential properties or 39 years for commercial properties). If you depreciate your assets on a shorter time schedule, then you will accelerate your depreciation deductions and reduce the amount of income tax you pay. This boosts your cash flow and allows you to keep more of your money now, maximizing the time value of money for you.
This article will focus on how cost segregation can benefit residential real estate investors. We will clear up some of the myths about cost segregation and provide you with an example of how cost segregation works in practice. But before we do that, let’s take a brief look at depreciation since we cannot understand cost segregation without having a firm grasp on depreciation first.
“Depreciation” is a term describing when something falls in value over a period of time. It is the opposite of appreciation, which describes an increase in the value of something over a period of time. Depreciation is also as a tax term used to describe the reduction in value of an asset over its useful life.
In the tax world, depreciation is a non-cash expense, meaning that it is an expense that is an accounting entry rather than an actual out of pocket cost. Yes, the IRS allows you to deduct this expense even though you are not paying any cash out of pocket! Businesses can deduct the depreciation expense for assets they purchase for business use in accordance with the IRS rules governing depreciation.
The IRS rules say that residential income producing property can be depreciated over a period of 27.5 years from the date it is placed in service (i.e., made available to rent). That means if you purchase a single family home for investment on March 1st, spend two months repairing it, put it on the market for rent on May 1st, and begin a new lease with a tenant on June 1st, then May 1st should be the date you use to begin depreciating the property.
In sum, depreciation is important because your depreciation expense (a non-cash expense that represents a decline in the value of your residential investment property over time) reduces your taxable income and, as you know, your goal as a real estate investor is to take full advantage of every legal opportunity available to you so you can keep as much of your money as possible instead of giving it to Uncle Sam to spend. Let’s take a look at a depreciation expense example.
Depreciation expense example
Using the straight line method of depreciation (meaning the aggregate depreciation expense is evenly distributed over the entire useful life of the asset) and without regard to your specific income tax bracket, suppose that you purchased a multi-family property for $700,000.00 on January 1, 2019. The land is worth $100,000.00 and the improvements are worth $600,000.00. January 1st is the date the investment property is considered placed in service since it is fully occupied by tenants when you close. The useful life of your investment property is 27.5 years.
Based on the above, the annual depreciation expense for your investment property is $21,818.18 per year from January 1, 2019 through June 30, 2046 (based on $600,000.00 of real estate improvements since the land is not depreciable). Let’s say that this investment produces $30,000.00 in income for you in 2019. The 2019 income attributed to you for this investment will be $8,181.82 ($30,000.00 income less $21,818.18 depreciation expense). That sounds great, right? It is great, but now let’s take a look at how using cost segregation can benefit you even more.
Implementing a cost segregation strategy
Before we get to the cost segregation example, let’s go over some of the cost segregation myths.
Myth 1: “Cost segregation is not available for residential real estate.” That is false. Cost segregation is available for all investment properties, whether they are used for commercial or residential purposes.
Myth 2: “Cost segregation only benefits very high-value properties.” This is also false. The Tax Cuts and Jobs Act of 2017 (the “TCJA”) doubled the “bonus depreciation” amount from 50% to 100% and extended this benefit to “used” investment property acquired after September 27, 2017. This change in the law makes cost segregation even more valuable to investors than it was before. We’ll take a look at “bonus depreciation” below.
Myth 3: “I will just pay back all of the depreciation later because of depreciation recapture when I sell.” While there may be a depreciation recapture liability upon the sale of your investment property, the depreciation recapture rate is currently 25% which is still well below the highest tax bracket for individuals (37% in 2018). Depending on your income tax bracket, you may have a lot to gain. Plus, when you deduct more depreciation earlier on, you will maximize the time value of money (having the use of money today is worth more than having the use of the same amount of money two years from now).
Myth 4: “A cost segregation study is too expensive.” Cost segregation studies are not free, but if you are able to save significant tax dollars early on, then the study will pay for itself from the tax savings you receive during the first year you benefit from accelerated depreciation.
Cost segregation example
Let’s say that you purchased the same multi-family property we discussed above in the depreciation example. You paid $700,000.00 for the investment property, $100,000.00 of which is attributed to land. As you recall, land is not depreciable under the tax code, so we are left with $600,000.00 to depreciate, but instead of simply classifying all of that as the building for tax purposes, your cost segregation study says that you can classify $100,000.00 as land improvements (depreciable over 15 years) and $75,000.00 as equipment (depreciable over five years). In addition to accelerated depreciation, you are also able to take advantage of “bonus depreciation” under the TCJA (you can take 100% depreciation for land improvements and equipment during the first year of depreciation). This is what your depreciation expense will look like for the first year, 2019.
|Investment Property ($700,000)||Depreciation Term||2019 Depreciation|
|Land Improvements ($100,000)||15 years||$6,667|
|Equipment ($75,000)||5 years||$15,000|
|Building ($425,000)||27.5 years||$15,455|
|Bonus Depreciation (100% of Land Improvements and Equipment for year one)||n/a||$175,000|
|TOTAL 2019 Depreciation||$212,122|
Wow! By taking advantage of cost segregation, you increased the depreciation deduction for your investment property in 2019 from $21,818.18 to $212,122.00. All you had to do was use the laws that were already in place. You might be thinking, “That looks really good, but my income for 2019 is only $30,000.00.” True. That is why you will recognize zero income from this investment property for 2019 and you will be able to carry the 2019 loss forward for future use.
This is free money! The wealthy have been taking advantage of laws like this since this country was founded. These benefits are available to everyone. So what are you waiting for? “Time is money!”
This article covers a few tax planning tips for investors interested in maximizing their benefits under the tax code’s cost segregation rules. Let us help you maximize the potential tax advantages available to you.
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