What You Should Know About Cost Segregation As A Landlord
September 30, 2022
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What You Need To Know About Cost Segregation
As a landlord, it’s important to understand how taxes can benefit your business.
One of the key things you need to know as a landlord is how to maximize depreciation deductions.
Cost segregation, in particular, can be an invaluable method of maximizing depreciation deductions.
Cost segregation involves taking advantage of shorter recovery periods by depreciating assets separately once a property goes into service.
If that sounds like a foreign language to you, don’t worry; it won’t after we’re through with this article.
What is Cost Segregation and Why is it Beneficial?
So, we have the technical definition, but what does cost segregation really entail? Essentially, the Tax Cuts and Jobs Act (TCJA) created a way to reduce taxes and increase cash flow. Instead of depreciating certain interior and exterior components over the typical 27.5 required for residential properties, or the 39 years for commercial properties, cost segregation allows you to separate and reclassify individual components of a property. You can convert them to personal property or land improvements, which are depreciated over five, seven, or 15 years.
Used personal property and land improvements put into service after September 27, 2017, are eligible for 100% bonus depreciation. You can deduct 100% of most personal property (traditionally over five years) and land improvements (traditionally over 15 years), all in the first year. The only thing required is a cost segregation study conducted by CPAs or qualified engineers.
For example, let’s say you bought a condo with a swimming pool in the back. You purchased the property in cash, including land improvements like the pool. Instead of depreciating the pool with the building for 27.5 years, you have a cost segregation study performed. As a result, you can depreciate the pool individually for 15 years as a land improvement.
And we’re not done yet. Due to the TCJA, you can also deduct most land improvements and personal property in just one year. In fact, the TCJA lets you use cost segregation to deduct an unlimited amount of items that qualify. And it can be applied retroactively as well.
Let’s go through a more involved example. Let’s say you purchase a multifamily duplex for $600,000, and the land it sits on was assessed at $100,000. Land isn’t depreciable for accounting purposes, so that cannot be depreciated. The purchase date was January 1, 2019.
Thus, over the standard 27.5 years, your annual tax deduction for the property is $18,181.81. If this duplex brings in $30,000 in rental income every year, your final reportable, taxable income for this property is $11,818.19 ($30,000 minus $18,181.81).
Now, though, let’s say you had a cost segregation study conducted. You learn from the study that you can classify $100,000 as land improvements and $50,000 as equipment. Because you purchased the property on January 1, 2019, you can also take advantage of bonus depreciation, according to the TCJA. (This will begin to change at the end of 2022, though, so be aware of that.)
So, the land improvements and equipment amount to $150,000 for 2019. And the building, which was $425,000, has $15,455 depreciable for 2019.
|Property ($600,000)||Depreciation Term||2019 Depreciation|
|Land ($100,000)||Not eligible||Not eligible|
|Land Improvements ($100,000)||15 years||$6,667|
|Equipment ($50,000)||5 years||$10,000|
|Building ($425,000)||27.5 years||$15,455|
|Bonus Depreciation||Not eligible||$150,000|
As you can see from the table above, cost segregation makes a huge difference. Your depreciation deduction went from $18,181.19 to $176,122. These tax benefits aren’t just available to wealthy people. Talk to your accountant and figure out what works best for you.
Issues With Cost Segregation
So far, cost segregation seems ideal, right? However, it does have some downsides. Let’s look at the main three right now:
Passive loss rules are the first issue. The large first-year deductions you can take using cost segregation sometimes lead to your rental property deductions exceeding the rental income earned from the property. Passive loss rules will prevent you from deducting losses over $25,000 unless you’re a real estate professional. And the $25,000 loss will still be rejected if your income is over $150,000.
This doesn’t automatically mean you should avoid cost segregation, though. Rental losses you’re unable to deduct aren’t necessarily “lost.” If you think you’ll have ample rental or other passive income to absorb your losses over time, cost segregation may still be worth it. However, if you don’t think you’ll have enough passive income to absorb your losses for a while, cost segregation may be a bad option.
Depreciation recapture is the second issue. If you don’t think you’ll hang on to the purchased property for long (over three to five years), then cost segregation probably isn’t a great option. When you sell a building, you must recapture the depreciation you took on the personal property and pay the taxes on it.
So, the longer you own the property, the less the depreciation recapture taxes will impact your wallet. This is because you will have years to take advantage of the additional tax savings gained from using cost segregation.
The cost of the cost segregation study can be the third issue. These studies aren’t cheap, so you need to make sure it’s worth your while. Therefore, it’s important to consider passive loss rules and depreciation recapture and understand your situation.
A thorough study done by cost segregation professionals typically ranges from $5,000 to $25,000. So, you should complete a cost-benefit analysis and ensure that this makes sense for your business. The studies usually take four to six weeks to complete. There are many benefits that often make it worthwhile, though. One example is that a business entity can deduct the cost of the study as a business expense (IRS section 162).
There is also an option to conduct a cost segregation study yourself. Thorough research will be required. The one major tip we’ll give you here is to keep records of exactly how you calculated everything.
Whether or not cost segregation is a good option depends on the factors we’ve discussed in this article. There isn’t a one-size-fits-all answer. You must analyze your situation and figure out the best move for your business. It can be a powerful way to save money on taxes for landlords, but it’s not ideal for everyone.