Landlording & Rental Properties

How to Use Cost Segregation to Increase Annual Depreciation (& Save Money!)

Expertise: Business Management, Landlording & Rental Properties, Personal Finance, Personal Development
65 Articles Written

When purchasing a property, the vast majority of landlords simply depreciate the improvement portion of the property over a 27.5 year (residential) or 39 year (commercial) period. If you read my prior article, you'll know how to determine the improvement value of the property you purchased to maximize your annual depreciation. But what if I told you we can take that one step further and substantially increase your allotted depreciation in the first couple of years you own the property?

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Depreciation is great because it's a phantom expense; however, the major downside is that it's a slow method of cost recovery. As a CPA, my goal is to maximize the amount of money my clients keep in their pockets, and a great way to achieve that goal is to frontload depreciation via cost segregation.

What is a Cost Segregation Study?

A cost segregation study allows landlords to take larger deductions by means of frontloading depreciation in the early years of a property’s life. The study will identify assets that are separate from the building structure (e.g. personal property and land improvements), classify those items within the General Depreciation System (GDS) and assign the items a “life” or number of years to depreciate the asset.

If you know anything about cost segregation studies, you'll know that they are expensive. Current market rates are anywhere between $10,000 to $20,000. This is mainly due to the complexity of the study and the cost of the professionals (usually engineers) performing the study. However, you can perform a cost segregation study yourself or with your CPA and focus on the items for which you can determine a fair market value.

Related: Your Tax Write-Offs Could Affect Your Ability to Get a Loan: Here’s How

Let's look at an example of how cost segregation can help your rental real estate business. The first table below depicts a standard scenario in which the purchase price is only divided between the land and improvements, which are subsequently depreciated over 27.5 years. The next table assumes that a cost segregation study of some degree is performed, and as a result, the landlord is able to take $4,426 more in depreciation during the first year of the asset's life. Of course these are made up numbers, but you can catch my drift.

Table 1

Table 2

Frontloading Your Depreciation

When you break out assets, such as personal property and land improvements, into GDS classes, you apply a shorter life to those assets and get to utilize an accelerated depreciation method, which will benefit you more in the short-term. This is what I was referring to as “frontloading” your depreciation deduction.

GDS five year property, such as appliances and carpet, will be depreciated using the 200% declining balance method. Using the straight line method, one would depreciate a five year property 20% each year, but using the 200% declining method, you accelerate your depreciation by multiplying the straight line percentage by a factor of two. So really, we get to depreciate the value by 40% each year. The catch is that you have to apply the 40% to the book value of the asset (the cost minus accumulated depreciation), so in future years, your depreciation write-off will decrease.

For example: You have a five year asset worth $10,000. In the first year, you depreciate it $4,000 ($10,000 x 0.40). In the second year, your depreciation shrinks to $2,400 [($10,000 – $4,000) x .4]. As you can see, the closer you get to the end of the useful life, the less your yearly depreciation write-off will become.

GDS 15 year property uses the 150% declining balance. The same logic from above is applied, but instead of using a factor of 2, you will use a factor of 1.5. Frontloading your depreciation can be a critical tax planning strategy to utilize because as we all know, a dollar today is worth more than a dollar tomorrow.

Focus on Items Where a Fair Market Value is Easily Identified

Leave the crazy stuff to the engineers. Instead, focus on the assets where a fair market value can be easily and readily determined, such as personal property and land improvements. If the asset is almost new, you can research the cost to replace the asset and use that cost as the asset’s tax basis. However, if the asset is a bit older, you will need to determine the current salvage value, or in other words, the amount you would be able to sell the asset for in today’s market. This is when it is a good idea to get with a CPA ,as there are a number of ways of determining the asset’s salvage value.

In addition to calculating the salvage value, you will want to substantiate your estimate with factual data from the actual sales. You can check Craiglist ads and eBay ads, preferably those that have been closed due to sales. You can call up or send surveys to vendors who trade those items and even ask them to provide you with a hard quote of what they would buy your asset for. If you have an expensive asset, you may wish to have a professional appraisal performed.

Most importantly, when determining a value, keep detailed documents defining your methodology and showing support for your calculations. Your documents should be detailed enough that a third party knowing nothing about you can come in and 100% understand and agree with your study.

Does a Cost Segregation Study Increase Audit Risk?

Get ready for a classic answer: it depends. It’s difficult to determine the factors that trigger an audit, and a cost segregation study alone will not substantially increase your audit susceptibility. However, if you are performing a cost segregation study for a property placed in service during a prior year (commonly known as a look-back analysis), you will need to file Form 3115, which may be reviewed by an IRS committee and can inherently increase your audit risk.

If you document your findings expecting to one day be audited, you will be fine. It’s important to note that the IRS has not established any requirements or standards for the preparation of cost segregation studies.  While the tax courts have previously addressed component depreciation, they have not specifically addressed the methodologies of cost segregation studies. Despite the lack of specific requirements, you will still need to substantiate your depreciation deductions and classifications of assets. In the event of an audit where estimates are used to determine fair value, the methodology and the source of any cost data should be clearly documented.

Related: 4 Depreciation Tax Mistakes Investors Need to Avoid

I’ll wrap up with the elements of a “quality” cost segregation study and report as defined by the IRS. If you follow their guidelines, you are more likely to be protected in the event of an audit. You may read more about them here.

A quality cost segregation study will have the following elements:

  • Preparation by an Individual With Expertise and Experience
  • Detailed Description of the Methodology
  • Use of Appropriate Documentation
  • Interviews Conducted With Appropriate Parties
  • Use of a Common Nomenclature
  • Use of a Standard Numbering System
  • Explanation of the Legal Analysis
  • Determination of Unit Costs and Engineering “Take-Offs”
  • Organization of Assets into Lists or Groups
  • Reconciliation of Total Allocated Costs to Total Actual Costs
  • Explanation of the Treatment of Indirect Costs
  • Identification and Listing of Section 1245 Property
  • Consideration of Related Aspects (e.g., IRC § 263A, Change in Accounting Method and Sampling Techniques)

A quality cost segregation report will have the following elements:

  • Summary Letter/Executive Summary
  • Narrative Report
  • Schedule of Assets
  • Schedule of Direct and Indirect Costs
  • Schedule of Property Units and Costs
  • Engineering Procedures
  • Statement of Assumptions and Limiting Conditions
  • Certificate
  • Exhibits

Investors: What are your questions regarding cost segregation?

I’d love to hear from you. Leave a comment below, and let’s talk!

Brandon Hall is a CPA and owner of The Real Estate CPA. Brandon assists investors with Tax Strategy through customized planning and
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    Darren Sager Investor from Summit, NJ
    Replied over 5 years ago
    Excellent article Brandon! This is something that most who buy and hold don’t know about and should. I’ll thank you for all those who don’t in sharing this with the community! Most focus on REI for the glamor we see on the TV shows. You’re helping us come to grip with some real world strategies that can make or break the bottom line. Again, Excellent article!
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Thanks Darren!
    Al Williamson Rental Property Investor from Sacramento, CA
    Replied over 5 years ago
    Well done Brandon!!! I prepare these studies for my properties. It’s good be an engineer. Also, as a tip for DIY’ers, be sure to keep your cost estimate documentation in your files.
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Thanks Al – great tip!
    Dave Stratton
    Replied over 5 years ago
    Excellent article and great information. When you sell the property, how do you calculate the recapture for taxes? If you sell it after 8 years, as far as appliances, do you have to go back and calculate the depreciation deduction for the first five years (assume you replaced them in the 5th year) and then the next three years. I have not sold one of my investment properties yet, but have never thought about the recapture on other items except the house. Thank you for the great information.
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Hey Dave, That can be a complicated question and best answered by a CPA that knows your financial position and all about your real estate portfolio. Feel free to connect if you’d like to discuss further.
    William Morrison Investor from Silver Spring, Maryland
    Replied over 5 years ago
    Brandon, if you are bound by Passive Activity Limits it may not be cost affective to pay someone to do the cost segregation, unless you see yourself changing to a full time professional later. I like using whatever method allows the most front loading even though much of the allowed depreciation and other losses for me is a carry forward. Speaking of front loading, I would be very careful about using “one time” special deals from the fed like our stimulus program “bonus depreciation” that has been renewed several times though 2014. It allows front loading that may decouple your federal tax return from your state return. You would want to do that on purpose, not by accident. If decoupled you will have to do two federal returns for the life of the depreciated item that the bonus was taken for. And depending on your limits may not change your taxes at all.
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Great point, thanks William!
    Geoff Van Dusen Property Manager from Sioux Falls, South Dakota
    Replied over 5 years ago
    Very interesting article, wanting to follow the responses as well.
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Thanks Geoff!
    Jen Shrock from North West, Pennsylvania
    Replied over 5 years ago
    Excellent article and a lot of food for thought for when I take the leap into buy and hold properties later this year. Thanks for explaining so clearly and giving cost breakdown examples.
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Thanks for reading Jen!
    Replied over 5 years ago
    So is this the difference between writing things off and having the things you write off work for you? I was impressed by all the things that I hadn’t even thought about, unlimited things around here to improve a persons game plan !!
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Thanks for reading Gary!
    Ben Parr Investor from Royal Oak, Michigan
    Replied over 5 years ago
    The downside here is that as your business and taxable income grow, you may have been better off saving those expenses for a bigger deduction later on.
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Hey Ben – thanks for the comment. I have to disagree with you here. As your business is growing, it’s imperative to maximize deductions and keep as much money (working capital) in your pocket as possible. Depreciation allows you to do this without actually having to shift your assets into tax shelter vehicles. Granted, the savings due to a change in tax brackets may be beneficial down the line by not frontloading, however current tax savings via a depreciation deduction allow a business to deploy more capital into investable assets today. The key here is that you will save a dollar today, rather than have that savings spread out over 27.5 years. You can then invest that dollar and likely earn a higher return than the savings you will earn (discounted to today) in future years.
    Ben Parr Investor from Royal Oak, Michigan
    Replied about 5 years ago
    Sorry for the slow reply, somehow I missed your response. You make some good points that are probably true for most investors, but for some tax situations you may be better off waiting to take the deduction. Say you are a full time investor with 30 houses and have no outside income. Say cash flow on each property is $2,500/year for a total income of $75,000/yr, and depreciation is $2,000 each or $60,000/yr. That leaves you with a taxable income of $15,000. Take out the standard deduction and two personal exemptions (for a married couple) and you owe no taxes. Taking a bigger deduction today does not save you anything as you are already paying nothing in income taxes currently,
    Patricia Hinojos Investor from Plano, Texas
    Replied over 5 years ago
    Great article, Brandon, and is exactly impacting my situation having just done a full rehab on a duplex (incl appliances, fence, lighting, flooring, roof, foundation, painting in & out…etc). We are buy-hold investors. Two questions: 1. How does the Chart of Accounts look for doing the segmenting rehab expense items (QuickBooks)? 2. Are there standard list/example somewhere to use when assigning the different depreciation length of time 5year, 10 year or 27.5 year?
    Geoff Van Dusen Property Manager from Sioux Falls, South Dakota
    Replied over 5 years ago
    Great question Patricia, if you find the answer elsewhere I would love to know what you find out.
    Brandon Hall CPA from Raleigh, NC
    Replied over 5 years ago
    Hey Particia, thanks for reading! 1. For your chart of accounts, you can create a separate account for each asset you are segmenting from the building. You will need to ensure that you decrease the building account for the amount transferred into the new asset’s account. The new asset’s account will be a non-current asset and you will need to make sure you have an accumulated depreciation account that corresponds with your assets. 2. Look at: “Which Property Class Applies Under GDS? “
    Jenny Bayless Real Estate Agent from Colorado Springs, CO
    Replied over 4 years ago
    Great article! Can you include installation of the component as part of the cost of the component? For example, the cost of laminate flooring material is $1000 and the cost of labor of the material is $1500, is my total laminate segregated component at $2500 or may I only use the $1000 as part of my 5 year property category? Thanks in advance!
    Rick Jones from Pennsburg, Pennsylvania
    Replied almost 4 years ago
    Brandon Hall Great article! Just curious as to what happens at the end of the last year. would you just write off the remaining cost basis on say year 5 on 5 year property? Can you use this method and then switch to straight line depreciation later? Also what happens if say you replace the carpets 3 years in, could you deduct the remaining basis of that item in the year they were replaced or would the cost basis of the new carpets be added to the cost basis of the old carpets? Thanks!
    Omar Khan Rental Property Investor from Dallas, TX
    Replied over 3 years ago
    This is an excellent analysis which is easy to understand implement. Thank you!
    Eric Barshinger Investor from Spring Grove, PA
    Replied about 3 years ago
    This was very enlightening. I have been depreciating everything at 27.5 years, and after reading this, I am excited to implement cost segregation studies on my own and create more cash flow for even more deals! Brandon, you are the best!
    Philip Potosnak Rental Property Investor from Greenville, South Carolina
    Replied over 2 years ago
    Brandon, Do you have to be a full-time real estate professional to reap the full benefits of cost segregation? Thanks, Philip
    Rick Jones from Pennsburg, Pennsylvania
    Replied over 2 years ago
    You certainly do not have to be a real estate professional to reap benefits of a cost seg. The only thing I can think of is that your ability to take passive losses against active income is phased out at incomes of 100-150k so depending on your situation if a cost segregation was going to produce a large passive loss and your job income is above the threshold it would be beneficial to be qualified as a “real estate professional” to take the full amount of the loss otherwise it would be carried forward.
    Suly B. Rental Property Investor from Denver, CO
    Replied almost 2 years ago
    Brandon, in your article you mention that a quality cost segregation study is complicated and expensive and you’re right! Unfortunately, not every CPA firm can afford to have onsite engineers and a legal team to produce a defensible report that follows the IRS audit technique guide. Anyway, my boyfriend and I are proud house hackers, we’re on to our 2nd property and a few months ago I was looking for ways to reduce his income tax liability. I came across a blog post published by Titan Engineering and I learned that the software engineers there built a Do-it-yourself cost seg app. It sounded too good to be true but I went through their self paced Learning Academy and successfully completed the cost seg study on my own. Long story short, I was so thrilled with the results I wanted to spread the word because I feel few people are aware of the benefits. I ended up working for the company but it’s too bad most people that can benefit from cost seg don’t know about it.
    Eric M. Flipper/Rehabber from Chicago, IL
    Replied over 1 year ago
    Maybe the app is awesome. I can just imagine being in an IRS audit and them saying who did your study? And me telling them….There is an app for that! I can just see them roll their eyes as they dig in.
    Aaron T. Developer from Tampa, FL
    Replied over 1 year ago
    Suly, thank you for your feedback with the App. I will take a look at it tomorrow. I have a couple new builds from the dirt, so i would think i would just use my numbers it cost me to build.