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October 18, 2024, BY Paul Tanso
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 a cost segregation study, 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 a cost segregation study 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 a cost segregation study 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.
Adjusted Basis = Original Purchase Price + Capital Improvements - Depreciation - Other Deductions / Adjustments
Original Purchase Price: The amount you originally paid for the asset/property. $3M in this example
Capital Improvements: Any expenses that improve or extend the life of the property, such as major renovations or upgrades (new roof, HVAC, etc.).
Depreciation Taken: The total depreciation taken on the asset over the years, reducing its basis. $865,455
Other Deductions/Adjustments: This could include costs like tax credits, casualty losses, or depletion (in the case of certain types of assets like oil or gas properties).
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.
Using the example above: Adjusted Basis: $3M - $865,455 = $2,134,545, so when you subtract the sale price of $5.9M from this number instead of the $3M purchase price you show a higher Capital Gains Tax.
Tip: This next part is key. This next part tripped me up when I recently sold a number of properties I owned for over 5 years. I did not understand that by "lowering" your adjusted basis the more of a profit you show on paper.
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.
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: A cost segregation study 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.
Is a Cost Segregation Study Worth It?
Here’s the bottom line: With a cost segregation study, 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 a cost segregation study, 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, a cost segregation study 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!
Conclusion: Wrapping Up Your Cost Segregation Strategy
Now that you’ve got a clear picture of how to maximize tax savings with a cost segregation study, whether it’s right at the time of purchase, after major renovations, or by leveraging bonus depreciation, you’re well-equipped to make strategic decisions for your real estate investments.
If you missed the earlier parts of this series, be sure to check out Part 1, where we discuss when to use a cost segregation study for maximum benefit, and Part 2, where we break down how the strategy works after major upgrades. Together, these three strategies can help you supercharge your real estate profits and avoid leaving money on the table.
Whether you’re new to cost segregation or an experienced investor, the key takeaway is this: By strategically timing and pairing these tax-saving methods, you can unlock the full potential of your investments.
What’s your experience with cost segregation? Have you tried leveraging it in your investments? Let’s discuss in the comments, or connect with me on Social for more real estate insights!
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