Since the landmark case of Hospital Corporation of America v. Commissioner, owners of real property have been afforded the ability to segregate certain components for accelerated depreciation deduction. Inherent to commercial and industrial properties the same benefits of cost segregation historically have not been financially practical for small, non-institutional investors, until now.
Rental real estate investors have long understood cost that investing in rental properties is one of the safest and most rewarding opportunities to build wealth. Among the considerations investors make in those investment decisions include:
- Stability. Unlike stocks, bonds, crypto, and similar, real estate is not potentially a volatile commodity.
- The return on investment, over the long term, exceeds other forms of wealth building.
- Predictable cash flow. As most real estate is controlled by lease agreements, the income from the lease is usually subject to longer-term commitments and steady cash flows.
- Diversification. Investments may be made in varying types of properties in addition to residential real estate to balance the risk of fluctuations in market segments.
- Long-term capital appreciation. As with any type of investment there is always the risk of a downturn in a market segment but over time real estate always stabilizes.
- Tax advantages. Depreciation deductions from real estate capitalization is one of the greatest offsets to income available as it is a non-cash hedge to other income, especially for high income earners.
IRS Cost Segregation for Real Estate
Cost segregation is a tax strategy used by real estate owners and investors to accelerate depreciation deductions on their properties. This approach involves identifying and separating the costs of various components of a property, allowing for shorter depreciation periods for certain assets.
Key Concepts of Cost Segregation
Depreciation: The process of allocating the cost of a tangible asset over its useful life. In real estate, this typically spans 27.5 years for residential properties and 39 years for commercial property.
- Depreciation: The process of allocating the cost of a tangible asset over its useful life. In real estate, this typically spans 27.5 years for residential properties and 39 years for commercial property.
- Asset Classification: Cost segregation studies classify property components into distinct categories, such as personal property (5, 7, or 15-year depreciation) and land improvements (15-year depreciation).
- Tax Benefits: By accelerating depreciation on certain components, property owners can significantly reduce taxable income in the early years of ownership, leading to increased cash flow.
Process of Cost Segregation
- Engagement of a Specialist: Property owners typically hire a cost segregation specialist or firm to conduct a detailed analysis of the property.
- Site Analysis: The specialist performs a physical inspection of the property to identify and categorize different components.
- Cost Allocation: Costs are allocated to the identified components based on engineering principles and tax regulations.
- Tax Reporting: The findings are documented in a cost segregation report, which is used to support tax filings and claims for accelerated depreciation.
Conclusion
IRS cost segregation can be a valuable strategy for real estate investors looking to maximize tax benefits and improve cash flow. By understanding and implementing this approach, property owners can effectively manage their tax liabilities and enhance their investment returns.
For decades, institutional investors have widely practiced cost segregation and enjoyed the resulting accelerated depreciation deduction benefits. However, traditionally, small non-institutional investors in residential rental properties have been unable to access these benefits because of:
- High Costs – With traditional cost segregation studies costing $4,000 or more, the cost to perform an analysis is cost-prohibitive for most small investors
- Accountants, CPAs, and financial advisers are not trained as construction cost professionals and do not have readily available construction cost data needed to perform a cost segregation study.
- Small, low-fee assignments are unprofitable and undesirable for cost-segregation practitioners.
Over time, the inability to economically develop cost segregations and benefit from
accelerated depreciation deductions has cost smaller investors millions, if not billions, in excessive taxes.
A Practical Solution
Fortunately, there is a sensible solution for non-institutional investors to finally use the tax code to their advantage. Recent advances in technology as artificial intelligence and the wide availability of access to building cost data has made it possible to develop statistically accurate models for cost segregation of small, residential rental properties.
Cost segregation specialists have brought very cost-effective products to market providing investors and their financial advisers and tax preparers the tools to fully implement the tax code provisions long enjoyed by large, institutional investors.
These accelerated depreciation programs are appropriate for:
- Single family rentals
- Duplex, triplex, and fourplex properties.
- Short-term vacation rentals
- Small (fewer than four unit) apartment buildings.
Cost segregation sample
Traditional capitalization techniques for small residential rental properties would deduct the land value from the acquisition cost to calculate the residual, depreciable value for the improvements. That residual depreciation amount would then be depreciated over a period of 27.5 years.
A cost segregation study would determine that significant components of the property acquisition include non-realty assets of 5-year depreciable personal property components ranging from approximately 18% to 22% and 15-year depreciable improvements to land ranging from approximately 9% to 13% of the total depreciable improvements.
Assume a property is acquired for $250,000. Since land is non-depreciable, the residual improvements of $212,500 are to be capitalized. Without a cost segregation study the entire residual of $212,500 would be capitalized for 27.5 years using straight-line depreciation method, yielding a first-year deduction of $7,727.
If a cost segregation study is implemented, the buildings (structural improvements) of approximate $141,295 would be capitalized for 27.5 years using straight-line method capitalization; $43,101 would be recognized as personal property (non- structural components) using a 200% double-declining balance method for 5 years; and approximately $28,113 of Land Improvements would be capitalized for 15 years using 150% declining-balance depreciation.
A cost segregation study increases first-year depreciation deductions from $7,727 to $26,127. An increase of 338%.
Statistically, investors hold rental real estate properties for about six to ten years. If the property was capitalized without segregation of the short-lived components, an investor will not fully recover the cost of those items.
As in the above sample, the property includes approximately $43,000 of personal five-year depreciable property and $28,000 of fifteen-year property. If the investor sold the property after seven years, they would only recover about $10,900 of the personal property asset costs and $7,100 of land improvement costs.
In this scenario, in addition to the missed increase in depreciation deductions, the investor may also bear the replacement cost of the depleted components.
It’s Not too Late
The IRS code provides a “look-back” provision to revisit prior years returns and implement a cost segregation study to claim depreciation not taken in prior years. The provision does not require filing amended returns but it can be advantaged by filing for a change of basis.
A look-back study will almost always provide for a huge windfall of unclaimed depreciation in the current tax year.
Using the “catch-up” provision of the tax code, a property originally acquired in 2020 using traditional capitalization filing for a change in basis for 2024 tax year could claim $71,846 in depreciation for the 2024 tax filing.
Import Considerations
- Accelerated Depreciation can significantly accelerate deductions, reducing current-year tax liability.
- Improved Cash Flow. The tax savings from increased depreciation can enhance an investor’s cash flow, which can be re-invested to grow the investor’s portfolio.
- Catch-Up Depreciation. Through a look-back study investors capture depreciation deductions in the current tax year without filing amended returns.
- Cost of Study. Traditional studies cost thousands of dollars but dfie to technical and information availability advances, studies now can be obtained for less than $500.00.
- Risk of Audit. There is no evidence of any increased risk of audit due to implementation of a cost segregation study. Proper reporting per the IRS “Audit Technique Guidelines” directs that assets must be properly classified into their proper asset class for depreciation calculations. If proper segregation of components is not performed, the filing is not in compliance with IRS guidelines.
- Recapture of tax. When sold, a rental property may be subject to recapture of the depreciation at 25% which potentially can lead to higher taxes upon sale.
The Bottom Line
Programs are available to property owners, accountants and financial advisers to provide suitable cost segregation services to small, residential rental property investors for a few hundred dollars.
Commercially available programs for small cost segregation programs are usually limited to properties with less than $1,000,000 of depreciable assets and are suitable for:
- Single family residential homes
- Duplexes
- Triplexes
- Fourplexes
- Vacation and short-term rentals.
- Small (four or fewer unit) apartment buildings
- Condominiums
The dynamics prove that a properly performed study can provide returns of 15:1 or
greater and any firm providing the service should be able to guarantee the benefit
will exceed the cost by a factor of 2:1 or greater.
About the Author
Don Feicht
After earning a degree in real estate with a minor in finance, the author spent the first years of his career as a construction cost estimator working on a variety of projects including single family and multi-tenant residential real estate and commercial and industrial buildings. In a career change, the author studied real estate appraisal and became a licensed Certified General Appraiser focused on property tax consulting. During this period while employed with a regional accounting firm he expanded his practice to include cost segregation consulting for large property owners of various property types including manufacturing facilities, commercial residential properties like apartment complexes, casinos, and many others.
Don formed his own cost segregation company, DP Feicht Company, LLC in 2016, continuing consulting for commercial and industrial clients. In 2024, Don formed Real Tax Advisers Co. to provide cost segregation services for non-institutional rental real estate after inventing the propriety algorithms that formed the basis for REALTAX SAVER residential cost segregation program.