Identify assets for tax purposes, optimizing depreciation schedules effectively.

What is Cost Segregation?

When you buy real estate to operate for your business or rent out to tenants, you can depreciate your cost over a period of time intended to approximate its useful life. Under current law, that’s 27.5 years for residential property or 39 years for nonresidential property. Depreciation is a key tax benefit that keeps the real estate merry-go-round spinning. If all goes well, you can put real cash in your pocket while using those depreciation deductions to avoid tax on that cash.

Having said that, depreciation is an art as well as a science. You can’t just throw the purchase price on a tax return and call it a day—not if you want to take maximum advantage of the law. There’s a whole industry of engineers and appraisers dedicated to helping you make the most of these valuable deductions. Let’s take a closer look at how depreciation works:

Cost Segregation Flowchart

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Let’s say you buy a house to rent to tenants. You’ll sign a single contract to take title to the property. And you’ll probably think of it as a single asset – your “rental house.” But you’re actually buying a whole collection of different assets: the land itself, the house that sits on the land, and the stuff inside the house. Tax law treats those assets differently – and the way you report those assets on your taxes can make a huge difference in the amount you can depreciate.

Start with the land. Raw land doesn’t “wear out.” It doesn’t ever need to be replaced. So raw land is nondepreciable. And that, in turn, suggests you want to allocate as little of your purchase price as possible to raw land. There are a couple of ways you can determine that amount. Your county auditor will assign a land value for local property tax purposes. Your appraiser may establish a different amount for your lender.

But even the land is a collection of assets. There’s land, and there are land improvements – driveways and sidewalks, landscaping, and pipes to and from the street. Driveways and sidewalks crack. Landscaping needs to be replaced. And pipes deteriorate over time. So you can depreciate land improvements over 15 years. Too many tax professionals fail to break out those assets and cost their clients substantial deductions.

Land:

Raw land is non-depreciable. But what about land improvements? Driveways and sidewalks crack, landscaping needs replacing, and pipes from the house to the street deteriorate over time. So you can depreciate land improvements over 15 years. If you miss those assets, you lose money!

Personal Property:

The same principal applies to the assets that make up the structure. It’s not just a single asset that you report on a single line of your tax return. You’ve got structural components that are permanently affixed to the property, governed under Code Section 1250. Those assets depreciate over 27.5 or 39 years. And you’ve got personal property included in the structure, governed under Code Section 1245. Those assets depreciate over 5 or 7 years. The principal here is the same as with land improvements. If you can break out the five-year components, you can depreciate them faster to increase your deductions in the early years of ownership.

Personal Property Examples Include:

  • Cabinets & Countertops, Appliances, Flooring & Carpeting, Window Treatments, Lighting, Wiring, Security & Sound Systems

Structure:

Cost segregation offers another benefit by separating out the components that make up the structure from each other. When you replace those components, you’ll be able to write off any remaining non-depreciated basis in them to offset the cost of replacement assets that you can’t immediately expense.

Let’s say you buy a four-family apartment building for $600,000. Naturally, it includes a furnace. Two years later, you replace it for $8,000. The furnace is a permanent part of the property, so you’ll depreciate it over 27.5 years and deduct $291 per year. But what about the old furnace? You’re still depreciating it as part of your original $600,000 for as long as you continue to own the property.

Now let’s say you do a cost segregation study. The appraiser assigns a value of $5,500 to the original furnace. You break it out from the rest of the $600,000 structure, and in your first two years, you depreciate $400. This doesn’t give you a bigger deduction because you’ll subtract that $5,500 from the overall $600,000 you paid for the building. But when you replace that furnace, you can deduct the remaining non-depreciated $5,100 as abandoned property. It’s not the same as expensing the $8,000 you pay for the new furnace. But it’s a lot closer, and it gives you the use of the tax savings on that remaining $5,100 now, rather than making you wait another 25.5 years.

Structure Examples Include:

  • Roof, Furnace/HVAC, Windows, Foundation

Deduction Comparison

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Deduction Comparison:

Let’s take a look at some numbers to see how much difference we’re really making.

  • We’ll assume that on July 1, you pay $600,000 for a four-family rental property. (The date is important because your first year’s depreciation is based on your purchase date.) Per the county auditor, $100,000 of that value attaches to the land. The remaining $500,000 depreciates over 27.5 years.
  • If you forego cost segregation, you’ll deduct $8,333 for Year 1, $18,182 per year for Years 2-27, and $9,848 in Year 28.
  • Now let’s see what happens with cost segregation. We’ll assume you can shift $20,000 of the $100,000 land allocation to land improvements, which depreciate over 15 years. We’ll also assume you can shift $100,000 of the $500,000 structure allocation to personal property, which depreciates over 5 years.
  • As you can see, cost segregation produces significantly bigger deductions in your first six years of ownership. You’ll deduct $16,444 in Year One—nearly twice as much as you would have without cost segregation. You’ll deduct $35,879 in Years 2–5—again, nearly twice as much as without. And you’ll deduct $26,712 in Year 6—still significantly more.
  • Once you reach Year 7, your deduction actually drops. In this example, it goes from $18,182 to $15,878. That’s because cost segregation isn’t primarily about creating new deductions (except where you shift from non-depreciable land to depreciable land improvements).

Want to Learn More About Cost Segregation? Let’s Talk! Schedule a 15-minute discovery call today.