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October 7, 2024, BY Paul Tanso
In the world of real estate investing, cutting down on taxes is almost as exciting as finding that perfect off-market deal. One way to keep more of your hard-earned cash (and who doesn’t love that?) is through cost segregation—a tax-saving strategy that lets you speed up depreciation and keep more cash upfront. But there’s a catch at the end when you sell. Don’t worry, though—we’ll break it all down with a few laughs along the way.
What Is Cost Segregation? (And Why Should You Care?
Imagine you just bought a rental property, and the IRS says, “Hey, you can write off part of the value of this property each year.” Great, right? Normally, you’d spread those deductions over 27.5 years, which is basically forever if you’re waiting to see some tax savings. But with cost segregation, you break the property into different parts—like the carpet, appliances, and landscaping—and write those off in 5, 7, or 15 years instead.
It’s like getting to eat dessert before dinner—you get those tax deductions faster, meaning less tax to pay today and more cash in your pocket. Who doesn’t love dessert first?
When Should You Use Cost Segregation?
Cost segregation is a powerful tax-saving strategy, but the real question is, when is the right time to use it, and how does it fit into your overall tax plan, especially if you’ve done major renovations?
The best time to perform a cost segregation study is after purchasing a property. This allows you to start accelerating your depreciation from the beginning and maximize the tax savings in your early years of ownership. However, there are a few scenarios where you might want to wait:
Right After Purchase: This is the perfect time to perform the study if you just bought the property. Starting early lets you capture the most depreciation in the first few years, lowering your taxable income and improving cash flow right from the start.
After Major Renovations: If you’ve made significant upgrades—replacing systems like HVAC, installing new windows, and siding, or redoing the driveway—it can make sense to wait until the renovations are complete. The new improvements will be included in the study, and their depreciation schedules will be categorized and accelerated based on their asset class.
A Year or Two After Purchase: If you didn’t perform a cost segregation study when you first bought the property, don’t worry—you can do it retroactively! You can still claim the missed depreciation through catch-up depreciation without having to amend past tax returns. This means even a few years after purchase, you can get a significant tax break.
Pro Tip: While it’s ideal to start as early as possible, you’re not out of luck if you wait. A cost segregation study can be performed even years after purchase, giving you substantial tax benefits whenever you decide to do it.
Pre-Assess for Success: Maximize Tax Savings Before You Renovate
If you’re planning to make major renovations to your property after purchasing it, here’s a strategy to consider: getting a pre-assessment before starting the renovations. This can help you plan your renovation budget strategically while maximizing your future tax savings.
Here’s why a pre-assessment makes sense:
Understand Existing Depreciation Potential: A pre-assessment will show you what portions of your property already qualify for accelerated depreciation. This gives you a clear idea of what tax benefits you can capture right away, allowing you to plan your renovations accordingly.
Renovation Strategy: By understanding how future renovations will be treated from a tax standpoint, you can prioritize the upgrades that will give you the most depreciation benefits. For example, certain items like carpets or fixtures can have faster depreciation schedules, so focusing on those upgrades may provide the best returns.
Avoid Missing Opportunities: If you don’t know the full depreciation potential of your property, you might miss out on deducting certain assets. A pre-assessment ensures that you don’t leave any money on the table when you perform the full cost segregation study after renovations.
Plan for the Full Study Post-Renovation: Once your renovations are complete, the cost segregation specialist will return to perform the actual study. This ensures that both the original property and the new improvements are categorized and depreciated for maximum tax benefits.
Pro Tip: Talk to your cost segregation specialist and your CPA before starting any renovations. They can help guide you through the pre-assessment process and provide a clear roadmap for your tax savings.
How Is a Cost Segregation Study Performed?
Performing a cost segregation study involves breaking down a property into its components—such as fixtures, carpets, HVAC systems, and landscaping—and assigning shorter depreciation schedules to the parts that wear out faster than the building itself.
Here’s how the process works:
Property Inspection: A cost segregation specialist will come to your property and review everything from flooring to plumbing, landscaping, and electrical systems. They’ll take note of what’s considered personal property (things like carpets and cabinets) and land improvements (like parking lots and driveways) that can be depreciated faster.
Engineering and Tax Analysis: The specialist will then categorize the property components based on IRS guidelines. Certain items—like the building structure—will remain under the 27.5-year depreciation schedule, but others (such as carpets or appliances) may be reclassified to a 5-, 7-, or 15-year depreciation schedule.
Report Creation: A detailed report is generated, showing how the property’s components are broken down and the new depreciation schedules. This report goes to your CPA, who will use it to adjust your tax filings and give you more deductions.
Who Performs Cost Segregation Studies?
Cost segregation studies require a combination of engineering expertise and tax knowledge. The professionals who perform these studies are often called cost segregation specialists, and they can be engineers, tax advisors, or consultants specializing in real estate tax strategies.
Here’s how to find a reputable one:
Look for Experience: Make sure the specialist has experience with properties like yours—whether it’s multifamily, commercial, or industrial real estate. You want someone who understands the nuances of your asset type.
Check Certifications: Reputable firms will often have CPAs, tax experts, or engineers on staff who are experienced in IRS guidelines related to depreciation.
Ask for References: Just like any professional service, ask for testimonials and references from past clients who saw tangible tax savings from the study.
Consult Your CPA: Your CPA may already have trusted relationships with cost segregation firms or specialists. Since they’ll need to work closely together, asking your CPA for a recommendation can be a smart move.
The Benefits of Cost Segregation (aka “Show Me the Money”)
Increased Cash Flow: Accelerating depreciation means you pay less in taxes early on. And less tax equals more cash for you. Think of it like finding extra fries at the bottom of the bag—it’s an unexpected bonus.
Tax Deferral: With cost segregation, you’re pushing some taxes down the road. It’s like telling the IRS, “I’ll deal with you later,” and in the meantime, you’re free to reinvest that cash or buy yourself something shiny (like more property).
Flexibility: If you’re holding a property for 5–10 years, this strategy works great. And if you do a 1031 exchange (which is basically hitting the IRS snooze button), you can push those taxes even further down the line.
The Risks of Cost Segregation (aka “What’s the Catch?”)
It’s not all roses and sunshine. There are a few things to keep in mind:
Depreciation Recapture: When you sell, the IRS will want some of that money back. It’s called recapture tax, and it’s kind of like when you lend a friend $20, and they come back two years later asking for $30. Sure, it’s annoying, but there’s still a net gain.
Upfront Costs: Doing a cost segregation study isn’t free. It can cost anywhere between $5,000 and $20,000, so you need to make sure the savings justify the expense. (Spoiler: It usually does with larger properties.)
Extra Complexity: Cost segregation adds a layer of complication to your taxes. This isn’t a DIY project—find a good CPA who knows the ropes, or you’ll end up with more headaches than tax savings.
Why Does Cost Segregation Exist? (And Who Do We Have to Thank?)
You might be wondering, “Why does cost segregation even exist, and who thought this up?” The answer lies in the tax code. Believe it or not, cost segregation is designed to encourage investment in real estate and boost economic growth. The IRS created depreciation rules to help property owners offset the natural wear and tear on buildings, recognizing that properties lose value over time.
But let’s face it, some parts of a property—like carpets, appliances, and parking lots—wear out much faster than the building itself. The IRS, being surprisingly logical on this one, says, “You don’t have to wait nearly three decades to write off your old dishwasher or crumbling sidewalk.”
So, cost segregation was born. It’s been around for a while, but it gained real momentum with the Tax Reform Act of 1986, which formalized the rules around accelerated depreciation. This was done to help real estate developers and investors keep more cash in their pockets sooner, allowing them to reinvest and build more, effectively stimulating the economy.
And who do we have to thank for this? Well, you could say Ronald Reagan. The Tax Reform Act of 1986, passed during his presidency, introduced a number of tax incentives aimed at fueling real estate development. Of course, tax attorneys and CPAs have refined the use of cost segregation over the years, making it a mainstream strategy for property owners.
In short, cost segregation exists because the government wants to incentivize investment, encouraging people like you to put your money into real estate and build something meaningful. So, every time you’re reaping the tax benefits of cost segregation, give a little thanks to tax reform, savvy tax professionals, and a system that actually benefits investors.
Cap-Ex vs. Repairs and Maintenance
When you perform major renovations on your property, it’s important to understand the difference between capital expenditures (Cap-Ex) and repairs and maintenance, as they are treated differently from a tax perspective.
Capital Expenditures (Cap-Ex): These are improvements that increase the property’s value or extend its useful life, such as a new roof, replacing major systems like HVAC, or installing new windows. Cap-Ex expenses must be capitalized and depreciated over time. However, cost segregation can accelerate the depreciation of some of these improvements (like carpets or landscaping) to shorter schedules.
Repairs and Maintenance: These are expenses that keep the property in good working condition but don’t necessarily add value or extend its life. Examples include patching a roof or fixing plumbing. These costs are deductible immediately in the year they’re incurred, providing instant tax benefits.
In short: Cap-Ex is depreciated over time, while repairs and maintenance can be written off immediately.
How Renovations Are Treated in a Cost Segregation Study
When you make major renovations—like replacing carpets, cabinets, siding, or driveways—a cost segregation study will categorize these improvements into the appropriate asset classes, accelerating the depreciation for certain components.
Here’s how it breaks down:
By performing a cost segregation study after renovations, you can allocate shorter depreciation schedules to personal property items like carpets, cabinets, and land improvements like driveways, accelerating your tax savings.
Bonus Depreciation
Under the Tax Cuts and Jobs Act of 2017, you may also be eligible for bonus depreciation, which allows you to deduct 100% of the cost of certain qualifying assets in the first year of ownership. Assets with a depreciation schedule of 20 years or less—such as carpets, appliances, and landscaping—qualify for this deduction. By leveraging cost segregation, you can identify which of your improvements qualify for bonus depreciation, further increasing your immediate tax benefits.
Note: Bonus depreciation is gradually phasing out after 2022, so it’s a great time to take advantage of it now.
Example Scenario: 16-Unit Property (Let’s Get to the Numbers)
Here’s a quick example to see how cost segregation works in real life, not just theory.
Initial Property Purchase & Cap Rate Analysis
Purchase Price: $3M
Cap Rate at Purchase: 6%
Rents at Purchase: $1,550 per unit x 16 units = $24,800 per month / $297,600 per year
Annual Net Operating Income (NOI): \frac{\$297,600}{6\%} = \$3,000,000
This confirms the $3M purchase price at a 6% cap rate. I know, more math, but hang in there.
Cost Segregation Study at Purchase
Here’s how a typical cost segregation study might break the property into parts for faster depreciation:
Category | Amount | Depreciation Schedule |
Personal Property (20%) | $480,000 | 5-7 years |
Land Improvements (10%) | $240,000 | 15 years |
Building Structure (70%) | $1,680,000 | 27.5 years |
In this case, instead of waiting almost 30 years to get those tax benefits, you start getting big tax deductions early on. Here’s how that looks:
Personal Property Depreciation: $96,000/year x 5 = $480,000
Land Improvements Depreciation: $16,000/year x 5 = $80,000
Building Structure Depreciation: $61,091/year x 5 = $305,455
Total Depreciation for First 5 Years: $865,455
Raising Rents Over 5 Years
You raise the rents to $1,850 per unit after 5 years, and now:
New Annual NOI: $355,200
New Sale Price (still at a 6% cap): $5.9M
Tax Implications Upon Sale (aka “The IRS Wants a Piece”)
When you sell, the IRS shows up asking for its share, thanks to the depreciation deductions you took over the years. This is where depreciation recapture tax and capital gains tax come into play.
First, let’s talk about recapture tax. You’ve taken $865,455 in depreciation deductions, which was great for lowering your taxes while you owned the property. But when you sell, the IRS says, “Hey, we want some of that back.” So, you’ll pay 25% of that amount as recapture tax.
Recapture Tax: $216,364
Now, let’s talk about the adjusted basis. Don’t worry, it sounds complicated, but here’s the deal: the adjusted basis is the original price you paid for the property, minus all the depreciation you took. Because you’ve been writing off part of the property’s value through depreciation, your adjusted basis goes down. The lower your adjusted basis, the higher your profit looks on paper when you sell.
Original Purchase Price: $3M
Depreciation Taken: $865,455
Adjusted Basis: $3M - $865,455 = $2,134,545
So, even though you didn’t necessarily pocket all that extra cash, on paper, it looks like you made more profit—so the IRS charges you capital gains tax on that larger profit.
Sale Price: $5.9M
Capital Gain: $5.9M - $2,134,545 = $3,765,455
Capital Gains Tax (20%): $753,091
Total Tax Liability (aka “Ouch, That’s a Big Number”)
Recapture Tax: $216,364
Capital Gains Tax: $753,091
Total Taxes Owed: $969,455
What Is “Adjusted Basis”?
Let’s pause for a second on adjusted basis because if you’re like me, the first time I saw this term, I had no idea what it meant. Here’s the deal:
Adjusted basis = what you originally paid for the property minus all the depreciation you took.
So, the more you depreciate the property, the lower your adjusted basis becomes. This means that when you sell, the IRS sees a bigger profit on paper—because the adjusted basis is now lower—and you end up paying more in taxes.
In other words, you’ve been lowering your tax bill each year by taking depreciation, but when you sell, that benefit flips, and your profit looks bigger, which means more taxes.
Is Cost Segregation Worth It?
Here’s the bottom line: With cost segregation, you save $150,179 in taxes upfront during those first 5 years. Sure, you’ll pay $107,273 more in recapture tax when you sell, but even with that, you’re still ahead by $42,906. Not bad, right?
Even after you pay the IRS back their share, you’ve been able to use more of your money sooner, giving you more opportunities to invest in more properties or grow your business.
Think of it like this: Would you rather keep more cash in hand now or wait 27.5 years for those tax benefits? By using cost segregation, you get to eat dessert first—and even though you’ll owe a little more at the end, you’re still coming out on top
So, if you’re serious about improving your cash flow and reinvesting, cost segregation could be a smart move. Just make sure you talk to a tax pro to figure out how it fits with your overall game plan. More cash today means more opportunities tomorrow—don’t leave money on the table!
I’d love to hear your thoughts!
Have you used cost segregation in your real estate investments? Do you have any questions or experiences with tax strategies that worked for you? Let me know in the comments—I’m always open to feedback, corrections, or new ideas. Let’s keep the conversation going!
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