Cost Segregation: Understanding the Benefit

Understanding the tax benefits of owning real estate can be a tremendous asset and allow you to grow your rental portfolio. 

Utilizing tax write-offs, pass-through deduction entities and avoidance of capital gains tax through deference (1031 exchange), you can keep more money in your pocket to be put towards obtaining additional rental properties and the associated cash-flow. 

Additionally, the IRS allows you to use a depreciation deduction to offset the incremental loss of your rental’s value.  This deduction is comparative to any other business expense and can be deducted off of your taxable income.  The IRS currently utilizes 27.5 years as the usual depreciation time frame for rental properties. 

As an example, if you purchased a property for $250,000 and the assessed land value is $40,000, you have a depreciable asset (in the IRS eyes) of $210,000.  When we divide $210,000 by 27.5 years, we can immediately deduct $7,636 off of our taxable income.  If we generate $15,000 in rental income, then the depreciation deduction allows our final reportable taxable income to be $7,364.

If the idea of using a depreciation deduction doesn’t sound appealing enough (and it should but also it’s required to depreciate your asset) there is actually a method to “accelerate deprecation” utilizing what is termed: cost segregation studies.  

In essence, cost segregation is a strategic tax planning method allowing taxpayers to increase their cash flow on rental properties by accelerating the depreciation deduction to which they are already entitled.  It allows the investor to reduce their tax liability which keeps more money in their business to acquire additional properties.

A cost segregation study dissects the construction or purchase price of a property and identifies all of the property-related costs that could be depreciated over a short interval, 5, 7, and 15 years.

Essentially, instead of spreading the depreciation of  a property over 27.5 years, this strategy front-loads the depreciation deductions into the early years of ownership.  The study allows you to identify various components of the property that can be depreciated on a much shorter schedule enabling you to take the tax deductions sooner.  

While a cost segregation study doesn’t allow you to depreciate “more” of the property it does enable you to receive the depreciation deductions much sooner.  So instead of waiting to receive that dollar in the future, you can receive it in the early phases which can accelerate your portfolio growth. 

How to Benefit?

Now that we understand the power of cost segregation studies, we can look at how they are beneficial for both the REPS and other taxpayers alike.

To qualify as a REPS, the IRS lays out certain things that you must do:

1. Participate in real estate 51% of your time. If you work a full-time job then qualifying as a REPS would be difficult to prove.
2. You must have at least 750 hours of material participation
3. You must have a log that provides the details of our material participation and the number of hours you spend on each property.
4. Include a form that aggregates all of your activities and properties.

As a qualifying REPS, the deprecation expenses created with a cost segregation study can be used to offset not only the passive income associated with the rental property but other sources of income as well.  The IRS doesn’t necessarily limit how the depreciation deductions are applied to your taxes which can significantly reduce your taxable income. 

Thankfully, the IRS does allow non-REPS qualifying investors to still utilize cost segregation studies to benefit their business.  However, they limit the depreciation expenses from the assets to only offset the income generated by that asset – not offsetting other income.  The reason cost segregation studies can still be appealing is because if the depreciation expenses exceed the rental income, the expenses can just be carried forward indefinitely to offset future rental income. 

Understanding potential legal and tax advantages of real estate investing can have tremendous returns to your business.  Many of these aspects are complex and have steep learning curves.  While the general idea of deprecation and use of cost segregation studies can be easily digested, the specifics of how to implement them into your business requires the use of experts.