Business Management

Cost Segregation Study: Could This Strategy Dramatically Reduce Your Tax Bill?

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I think it’s safe to say that no one likes paying taxes. That’s why it’s important to do some tax planning each year to make sure that you’re not missing out on legal deductions you may be entitled to. One powerful strategy that may help investors reduce their tax bill is a cost segregation study. If you own rental properties, this is a way to deduct depreciation faster and take more losses now in the early years of owning your rentals. Let’s take a look at what it’s all about.

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Cost Segregation Study: How Does it Work?

Generally when you place a rental property into service, the values of the land and building are separated based on what the county assessor has determined, and the building portion is depreciated over 27 ½ years if it is a residential rental or over 39 years if it is a commercial property. This term “building,” however, is a bit misleading because it generally includes a lot more than just the building. While the building value includes structural components, it also includes light fixtures, cabinets, fences, flooring, and other items that have a much shorter life than 27 ½ years. A cost segregation study is a way to split up the building further and depreciate each component separately over its normal life, which could be as low as 5 or 7 years. This is strategy is also referred to as “accelerated depreciation.”

Related: Will My Flips Qualify for Long-Term Capital Gains or Will I Need to Pay Self-Employment Tax?

Recently, I came across an investor named Nick who contacted a cost segregation firm after reading online about the wonderful benefits of this strategy. Nick was a smart guy and had done his own taxes for years. After getting the cost segregation study done, Nick was extremely happy to find out that he was able to double his depreciation deduction. He purchased a $700k commercial building in 2014, and the result of the cost segregation was that it would double his depreciation by increasing it from $19k to $40k by splitting part of his building into 5 and 15-year assets. It doesn’t stop there: Nick will benefit from the accelerated depreciation for several more years since it will take time to fully depreciate the 5 and 15-year property.

The Catch?

Cost segregations are not guaranteed successes, and they are also not free. Nick spent around $5k to have the study done for the property, and it did gain him over $20k of deductions. His study actually doesn’t seem too pricy in comparison to the tens of thousands of dollars that some investors spend to have multiple properties done. Therefore, make sure that the cost segregation is actually worth the price you pay.

I’m sure you’re thinking that Nick got a great benefit from his cost segregation. However, you’re actually wrong! In the end he received no current year benefit from this study and missed out on reducing his 2014 tax bill by about $6,500 due to just one oversight. What was the mistake, you ask? Nick did not qualify as a real estate professional. His additional $20k of real estate deductions will now carry forward indefinitely until he qualifies to take the losses when one of these occur:

  • Nick or his wife qualifies as a real estate professional
  • When his W-2 income falls below the $150k threshold, or
  • Until he sells the property.

I am not saying that you have to be a real estate professional to benefit from a cost segregation, although it may help in many situations. If your other income is below the $150k threshold or if your properties have significant income, then you may not need the real estate professional designation to benefit from a cost segregation. Each situation is unique, and it is important to discuss your options with your CPA prior to hiring a cost segregation team.

The last downside is that several years from now, when the 5 year and 15-year properties are fully depreciated, Nick’s depreciation deduction will be much smaller than what it would have been without the cost segregation. Instead of having a $750k building with $19k of depreciation each year, he may be left with a $544k building with $14k of depreciation each year.

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

Will It Benefit You?

The good news is that this is one of the few tax saving strategies that does not have to be done by December 31st. If in March or April you and your CPA determine that a cost segregation would be helpful, you can have one done during 2016 for the 2015 year. Also, be wary of what advice you are given, as I have come across lots of investors who are misled by their CPA into thinking that a cost segregation can only be done in the year of purchase for the property. The truth is, a cost segregation can be done at any time during the ownership of an investment property.

The lesson here is don’t end up like Nick. Before hiring a team for a cost segregation study, make sure that you can actually take the deduction for the accelerated depreciation and that the benefit is greater than the cost of the study. Remember that this powerful strategy is only effective if done correctly.

Investors: Have you used this strategy before? Any advice or questions?

Leave your comments below!

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 years with a focus on long-term hold residential and multi-family assets across multiple states. Formerly a tax advisor at the prestigious accounting firm Deloitte in the Lead Tax Group, focusing on tax strategies for the real estate industry and high net worth individuals, and at an international Fortune 500 Company in the high-tech industry in the Corporate Tax department, Amanda’s goal is to help investors with strategies designed to supercharge their wealth building. Amanda’s highly rated book Tax Strategies for the Savvy Real Estate Investor is amongst Amazon’s best seller list. A frequent contributor, speaker, and educator to some of the nation’s top investment and self-directed IRA companies, Amanda has been featured in prominent publications including Money Magazine, Realtor.com, and AllBusiness.com. Amanda was a speaker at Talks at Google and is a 40 under 40 honoree by CPA Practice Advisor, showcased amongst the best and brightest talent in the accounting profession. Her firm Keystone CPA, Inc. was awarded a two-time winner of the Top CPA of Orange County Award by OC Metro Magazine. She is certified by the CA State Board of Accountancy and is a member of the prestigious American Institute of Certified Public Accountants (AICPA) with clients across the nation.

    John C. Carlson appraiser from Victorville, California
    Replied almost 4 years ago
    Thank you for this post!
    Amanda Han accountant from Fullerton, CA
    Replied almost 4 years ago
    You’re welcome John
    Vinil Ramchandran from Long Beach, California
    Replied almost 4 years ago
    You make a great point, Amanda! My company does cost segregation studies, and our policy is to ensure the client can utilize the benefits by talking to their CPA before actually initiating the study. Quite often, the client is confused about their own upcoming tax liability, and getting the CPA involved early ensures the whole process goes smoothly!
    Amanda Han accountant from Fullerton, CA
    Replied almost 4 years ago
    Yes, getting your CPA involved early goes a long way! Thank you Vinil.
    Tracy Layton from Burleson, TX
    Replied 11 months ago
    How does being a real estate professional come into play? I own 7 rentals in an LLC and I also have my real estate broker’s license. Thanks in advance, Tracy