Cost Segregation
Cost Segregation

Understanding Cost Segregation for Rental Property: A potential tax-saving windfall

What would you do with a significantly lower tax bill, or even a refund this year? Thanks to special tax rules affecting rental property, you may be able to significantly improve your cash flow by commissioning an engineering firm to conduct a cost segregation study for your commercial, long-term, or short-term rental property. Thanks to the Tax Cuts and Jobs Act, cost segregation for rental property is offering rental owners a significant opportunity for tax planning. 

What is cost segregation for rental property? 

If you are planning to build, purchase, or renovate your rental property, or have done so in the past several years, a cost segregation study is a powerful tool that may help boost your cash flow and decrease your tax liability. 

Cost segregation is a valuable tax planning tool used to separate real property into various depreciable categories. Doing so allows the taxpayer to depreciate the property over much shorter periods of time than the typical 27.5 or 39-year periods that are standard for real property. By conducting a cost segregation study, you can separate out the various components of your property whose costs can be depreciated on a shorter schedule (or even deducted at full cost thanks to bonus depreciation) and take the tax deduction sooner.

If you’ve made significant improvements to your rental property—such as state-of-the-art appliances or adding a pool—you may want to consider investing in a cost segregation study. A cost segregation analysis can help you reduce your tax burden by allowing you to write off the costs of those improvements on an accelerated schedule—often even in the same year if you have enough rental income to offset them. 

What are the benefits of a cost segregation study for rental property?

Even though you’ll take the same total depreciation amount over the property’s lifetime, a dollar invested and compounded over time is more valuable than a dollar received in the future. With a cost segregation study, you’re able to front-load your depreciation deductions and take them sooner. The money can also be used for any immediate needs to prevent you from going into debt and incurring interest. 

Benefits of a cost segregation study include:

  • Significant increase in cash flow
  • Decrease in current tax liability
  • The ability to defer taxes
  • An opportunity to reclaim depreciation deductions incurred in the past

Another benefit comes in the disposition of components. Because a cost segregation study breaks out the different components of your building, you can easily assign a value to anything you need to repair or improve in your building. When you replace a specified component, you can assign a value to the old component and write off its remaining undepreciated basis. For example, say you segregated out the HVAC system, and then needed to install a new AC unit a few years later. Because the HVAC was segregated, you can claim a loss on the AC unit and deduct the cost of its replacement. The cost study component write-off amount is usually larger than the amount you would get by basing your write-off on the IRS formula. 

READ MORE: Tax tips for Airbnb and short-term rental property owners 

How does cost segregation for rental properties work?

When you purchase a property, including a property to be used for rentals, you acquire more than just a structure: you’ve gained a set of building components. You may see a single property, but as much as 40% of the building’s parts and pieces may be looked at differently by the IRS. 

While most structures are depreciated over 39 years (27.5 years for residential properties), some components of your property can be depreciated over five, seven or 15 years. Instead of breaking your property into two assets for depreciation purposes (non-depreciable land and depreciable building), cost segregation turns your property into much more than a building on land. 

When you commission a cost segregation study, you’re essentially allocating each of your property-related costs into their appropriate property classes for a more accurate calculation of depreciation deductions. Some examples of typical items that can be reclassified by a cost segregation study include: 

  • Flooring
  • Appliances
  • Countertops
  • Signage
  • Lighting
  • Cabinetry
  • Landscaping
  • Sidewalks
  • Parking lots

Who can conduct a cost segregation study?

For tax purposes, the IRS requires cost segregation studies to be done by an engineering firm. The cost of the study will vary depending on the size of the property, building type, and other physical characteristics. 

If a cost segregation study has the potential to accelerate your depreciation deductions and put more after-tax cash in your pocket, it’s certainly worth doing. Thanks to tax reform’s 100% bonus depreciation and expansion to include used property, cost segregation can give you even better up-front tax deductions than you may receive following a traditional depreciation schedule for the property as a whole. Passive loss and aggregation rules can have a significant impact on the benefits derived from a cost segregation study.

Please consult with our Jacksonville-based team to review your unique situation to help you make an informed decision.

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