Commercial Real Estate

Why Real Estate Investors Need to Pay Attention to Cost Segregation

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5 Articles Written
calculator with less tax and more tax buttons

Ah yes, the wonderful life of a real estate investor. In between the passive income generated and tenants calling you at midnight complaining about broken heaters, there is one savvy tax savings strategy that is often misunderstood—or just plain unheard of.

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But the end result of this strategy can yield upfront cash flow faster for investors and help reduce your current tax liability at the same time. Do I have your attention yet?

If you’re ready to hold onto more of your hard-earned cash, say hello to cost segregation.

dollars, change and a toy home stacked on top of tax filing paperwork

What is Cost Segregation?

Cost segregation is a tax planning strategy used by real estate investors that accelerates the depreciation of certain components of their properties. This amounts to a reduction in your current tax liability, resulting in upfront cash flow.

How exactly does it work? According to the IRS, a building normally depreciates its value over 39 years (non-residential) or 27.5 years (residential).

So, let’s say you own a residential rental property. Without cost segregation, your property would be depreciated consistently (known as “straight line”) over 27.5 years.

Sure, that’s great and all, but everyone knows that most components, like carpeting, landscaping, appliances, and cabinetry, don’t last 27.5 years—particularly in rentals.

With cost segregation, you can reclassify a portion of your assets as personal property instead of real estate property in order to depreciate them on a much, much faster schedule (such as five, seven, or 15 years) for tax purposes. This lessens your tax burden, thereby leaving you with more profit. 

What Are The Financial Benefits Of Cost Segregation?

Put simply, offsetting passive income through accelerated depreciation!

Below is a before and after scenario for Joe the Real Estate Investor:

chart comparing depreciation with and without cost segregation

Almost $5,000 in tax savings? Not too bad if you ask me!

How did I calculate that? Depreciation is an expense against income, like operating expenses. With the $33,791 in depreciation captured through cost segregation, Joe was able to claim that total as a loss, thus reducing his total taxable income even further to $1,209 versus $23,706. 

Why Cost Segregation is More Beneficial Now Than Ever

With the enactment of the Tax Cuts and Jobs Act (TCJA) of 2017, we saw an increase in first-year bonus depreciation from 50 to 100 percent. With that said, I cannot stress how much more valuable cost segregation is to real estate investors. A cost segregation study will help you determine which assets qualify for 100 percent bonus depreciation.

It is important to note that not all assets will pass the test. To be eligible, assets must have a tax recovery period of 20 years or less. Additionally, used property must have been acquired and placed in service on or after Sept. 28, 2017, and before Jan. 1, 2023.

Conclusion

If you’re ready to reduce your current tax liability and take advantage of this “gem” of a strategy, make sure to check with your CPA beforehand to ensure cost segregation makes financial sense for you.

Then when you’re ready, find a reputable company who does cost segregation utilizing the engineering approach. According to the IRS, this approach is considered the most accurate and defensible. Better to be safe than sorry!

Do you understand the changes that came with the TCJA of 2017 with regard to cost segregation? Any follow-up questions for me?

Comment below. 

Mary is a Marketing Manager for a cost segregation software solution, Titan Echo (www.titanecho.com), located in BiggerPockets' hometown - Denver, Colorado! Mary was first introduced to the world of real estate investing when starting at Titan Echo. In her spare time, Mary enjoys exploring the Denver food scene or cooking in the comfort of her kitchen.

    James Gorman IV Investor from Gig Harbor, Washington
    Replied 6 months ago
    Thanks for this heads-up post. Well done! Yes, the engineering approach is the better way to go, particularly with larger scope single or multiple contract work. It is hard to rationalize that a tax payment is not a LOSS. Is it not? Understand your options in a IRS 721, 1031 & 1033 Exchange is also.
    Mary H.
    Replied 6 months ago
    Thanks for the comment, James! The engineering approach is the best way to go!
    David Cruice Rental Property Investor from South Florida and North Carolina
    Replied 6 months ago
    Mary, thanks for the article. I greatly appreciate it. While tax-related posts are not the most appealing “page turners” they are invaluable to taking one’s real estate investment strategy to the next level. Quick question for you: What, would you say, is the minimum threshold (with respect to property basis) for conducting a cost segregation study to make the ROI worthwhile? I used to read that it was $1,000,000; then I started seeing $500,000; now I’m seeing some people (usually providers of cost-segregation studies) claiming that the basis can be as low as $300,000. When I see numbers this low I begin to question the motives of such providers, since it looks like they’re just trying to line their own pockets at the expense of the client who would receive very little, if any, benefit from conducting a study on a property with such a low basis. Thanks.
    Mary H.
    Replied 6 months ago
    Hey David, Great question! Doing full-blown cost seg can be prohibited. I’ll add you as a connection and send you a message with more information offline. Thanks!
    Mary H.
    Replied 6 months ago
    Hey David, Great question! Doing full-blown cost seg can be prohibited. I’ll add you as a connection and send you a message with more information offline. Thanks!
    Jeff White Rental Property Investor from Denver, CO
    Replied 6 months ago
    David, I thought the same thing as you, why would anyone do cost segregation on properties under a 500K basis… but after doing some research, I did find a solution that’s much more affordable than a full blown cost segregation study, and the savings are about the same. I have a property with a cost basis of 300K, and after talking to my CPA, the tax savings for me will be about 5K using this solution, and the cost for it is much less than a full cost segregation study as well. Also, just be to sure, I did confirm with my CPA that this approach is legit, and it is outlined in the IRS website as the sampling or modeling approach to cost segregation.
    Mary H.
    Replied 6 months ago
    Thanks for the input, Jeff! Glad to hear that you found a solution that worked for you! It’s great to know that there are options out there!
    Patrick Henry from stockton, CA
    Replied 6 months ago
    Great article. I’ve thought about when to use cost segregation too, and am still a little stumped. My game plan at this point is to purchase rentals that cash flow in the $100,000 range. So far I’ve bought 2 (in late 2017 and 2018) and will be looking to find my 3rd sometime in the 2nd half of this year (Possibly a 2-4 unit property). Any advice on some simple math to use when trying to figure out if it will be worth it to pay for the cost segregation? I’m all for trying to keep some more of my money so I can invest in something else sooner and grow my portfolio. Any thoughts on how the tax savings works in regards to when you sell the property or 1031 exchange it? For instance does that savings work like regular depreciation when you sell the property, and does the cost segregation work on top of the regular depreciation for the 27.5 yrs (Residential)? Too many other questions to ask. Thanks again for the article. This concept is very intriguing. Keep moving forward on your goals everyone!
    Mary H.
    Replied 6 months ago
    As a quick rule of thumb, you could expect to reclass between a quarter and a third of the basis of the building as personal property. Of course, it can certainly be more than that as every property is different. This is the rule of thumb. The challenge, of course, is utilization. Stay tuned I got a blog post coming back breaks that down. In regards to 1031, it’s a great question but a complicated subject. It’s beyond the scope of this blog post, but I am happy to get you on a call with my engineer so he can help you with your particular situation.
    Kris Wong Rental Property Investor from Austin, TX
    Replied 6 months ago
    It seems a little misleading to not mention in your article that by accelerating depreciation, you are deferring taxes until the eventual sale of the property, at which time you will have to deal with depreciation recapture. I think it’s also important to mention that there are many cases in which cost segregation may not be beneficial at all. Net income has to be higher than expenses plus straight line depreciation, or the investor must be able to utilize those passive losses in another way (many can’t, including myself). There are many considerations in the decision to do a cost segregation. That being said, cost segregation can be fantastic in certain scenarios (like for real estate professionals).
    Mary H.
    Replied 6 months ago
    Hi Kris, You bring up some great points. It is true, cost segregation doesn’t make sense for everyone, especially if your net income isn’t high enough. That’s why I always advise potential clients to always make sure with their CPA that cost segregation makes sense as they know your financial situation intimately. Thanks for your comment!
    Deepika Tandon Investor from Chico, California
    Replied 5 months ago
    It is important to note that not all assets will pass the test. To be eligible, assets must have a tax recovery period of 20 years or less. Additionally, used property must have been acquired and placed in service on or after Sept. 28, 2017, and before Jan. 1, 2023. We have a property we purchased in May 2017, are we eligible to take advantage of cost segregation.
    Mary H.
    Replied 5 months ago
    That’s correct. That’s where a cost seg study comes into play. It will help you understand which assets can/cannot qualify. As far as your property, a cost segregation study can be done anytime during your ownership. This is what we call “catch-up” depreciation. It’s the depreciation you would have gotten if you did cost segregation during the first year. Keep in mind that in order to do this, the law requires you to file a Form 3115 Change in Accounting Method.