Are you a real estate investor or business owner looking to maximize your tax savings? If so, you may want to consider cost segregation and bonus depreciation. These tax strategies can help you accelerate depreciation of certain assets such as rental properties and commercial properties and take advantage of significant tax benefits.
In this article, we’ll explore what cost segregation and bonus depreciation are, how they work, and how to reduce taxes for high income earners. Whether you’re a seasoned investor or just getting started, understanding accelerated depreciation can help you make more informed financial decisions and keep more money in your pocket.
What is Cost Segregation & Accelerated Depreciation?
In simple terms, cost segregation allows businesses to identify certain assets within a building that can be depreciated faster for tax purposes than the building itself. By doing this, businesses can reduce their taxable income and increase their cash flow in the short term.
For example, instead of depreciating a self storage property over 39 years, a business may identify certain assets, such as electrical systems or security systems, that can be depreciated over a shorter period of time. By taking advantage of accelerated depreciation, business to take larger tax deductions on real estate in the earlier years of ownership. Typically when they may need cash flow the most.
Cost segregation can be a complex process that involves detailed analysis and documentation, so it’s typically performed by tax professionals with expertise in this area.
What is a Cost Segregation Study?
A cost segregation study (or simply “cost seg study”) is a tax planning strategy that allows real estate investors and business owners to take advantage of cost segregation.
Typically, buildings are depreciated over a period of 27.5 years for residential properties and 39 years for commercial properties. However, a cost seg study is the first step that investors and business owners can take to reduce their taxable income.
For example, items like floor coverings, appliances, cabinets, countertops & light fixtures may be depreciated over a much shorter period, often just five or seven years. In turn, this will also increase cash on cash return for real estate investors.
A cost seg study typically requires the expertise of professionals such as CPA’s, engineers, and tax specialists. Tax preparers often charge a flat rate determined by the size of the asset for a cost segregation study. The cost can range anywhere from $1,000 for smaller multi-family properties to $20,000+ for larger commercial assets. However, the benefits can be substantial, making it a valuable tax planning tool for those who own or invest in commercial and residential real estate.
Cost Segregation Study Example
Cost segregation can be a difficult concept to grasp at first. Here is a cost segregation study example that will allow you to gain a better understanding of how the process works.
Let’s say you purchase a multi-family apartment building with 12 units for $1 million and would like to reduce your tax liability using accelerated depreciation. A cost segregation study can help you achieve this goal.
First, a qualified cost segregation engineer would visit the property to conduct a visual inspection and gather information about the building’s components. During the inspection, the specialist identifies assets that can be reclassified from real property to personal property or land improvements.
The IRS defines personal property as property that can be easily replaced without affecting the building’s structural integrity. Instead of depreciating personal property over 27.5 years, the depreciation can be accelerated to 5 years.
Land improvements would include items like concrete paving, decking and landscaping. Anything that falls into the land improvements category would have a shorter depreciation schedule as well, typically 15 years.
After gathering all necessary information, the specialist would then use cost segregation software to calculate the appropriate asset classes, recovery periods, and depreciation methods for each reclassified asset. The cost seg study report provides a detailed breakdown of the building’s components and their respective depreciation schedules.
Here is cost segregation study example for the 12 unit apartment building purchased for $1 million. These are just estimates but is pretty close to what you could expect.
Land Improvements (15 year)
- Concrete Paving: $15,000
- Landscaping: $12,000
- Wood Decks: $30,000
Personal Property (5 year)
- Appliances Residential: $20,000
- Cabinetry: $50,000
- Cable TV System: $2,000
- Carpeting: $60,000
- Countertops: $25,000
- Dryer Vent Kits: $700
- Lighting: $8,000
- Sink Rough Ins: $15,000
- Special Purpose Electrical: $12,000
- Special Purpose Plumbing: $4,000
- Telephone and Data Systems: $1,300
- Vinyl Floors and Base: $30,000
- Window Treatments: $10,000
- Wood Base: $6,000
Building Estimate (27.5 Year Life)
- Block Wall: $50,000
- Double Hung Windows: $25,000
- Drywall and Thincoat Ceiling: $10,000
- Drywall and Thincoat Wall: $35,000
- Electric Service: $8,000
- Entrance Doors: $12,000
- Exterior Wall Framing: $45,000
- Floor Framing (Wood): $40,000
- Floor Slab: $10,000
- Flooring: $20,000
- Footings: $12,000
- Footing Excavation: $7,000
- Gable End Roof Framing: $22,000
- Gable End Roofing: $20,000
- Gas Fired/Heating & Cooling: $25,000
- Insulation: $8,000
- Interior Doors: $30,000
- Lighting Systems, Cost per System: $6,000
- Mods, Adjs, Alts & Upgrades: $26,000
- Partition Framing: $8,000
- Stairways: $10,000
- Storm Door & Windows: $5,000
- Three Fixture Bathrooms: $70,000
- Wiring Device: $2,000
- Wiring Device System, cost per system: $8,000
- Wood/Vinyl Siding: $35,000
Land Value @ 15% (no depreciation): $150,000
Accelerated Depreciation Totals for Land Improvements (15 year schedule): $57,000
Bonus Depreciation Totals for Personal Property (5 year schedule): $244,000
Total Depreciation on Building (standard 27.5 year schedule): $549,000
In this cost segregation study example, you would be able to take 100% bonus depreciation on the $57,000 for land improvements and $244,000 for personal property. That would be a potential $301,000 deduction during the tax year you acquired the property.
DIY Cost Segregation Study
Property owners may be able to conduct a DIY cost segregation study without the help of an engineer or tax specialist. Here are the steps you need to follow to conduct a DIY cost segregation study:
- Identify the assets: Make a list of all the assets within the property, including itemized building components, land improvements, and personal property.
- Classify assets: Classify each asset into one of the following categories: land, building, or personal property. Personal property includes items that are not structural components of the building, such as furniture, equipment, and appliances.
- Determine the useful life of each asset: Use the IRS guidelines to determine the useful life of each asset. The IRS has published guidelines on the depreciable life of various assets, which can be found in Publication 946.
- Allocate costs: Allocate the cost of each asset to its respective category, based on its useful life.
- Assign values: Assign a value to each asset, based on its fair market value at the time of acquisition.
- Apply depreciation methods: Apply the appropriate depreciation method to each asset, based on its category and useful life.
- Calculate the tax savings: Compare the total tax savings from the cost segregation study with the cost of conducting the study to determine if it is a worthwhile investment.
While conducting a DIY cost segregation study can be a cost-effective way to increase tax savings, it’s important to note that the process is often very time-consuming. This is why it’s recommended to consult with a qualified tax professional to ensure that the study is done correctly and to maximize your tax savings.
Bonus Depreciation Residential Rental Explained
Bonus depreciation for a residential rental is a business tax incentive that allows investors and entrepreneurs to immediately deduct a certain percentage of the cost of qualifying property from their taxable income. In the context of residential rentals, bonus depreciation can be applied to certain types of property, such as equipment or improvements, that are used in a business setting.
For a residential rental, bonus depreciation is typically applied to assets that have a useful life of 20 years or less, such as HVAC systems, security systems, or certain types of flooring.
It’s important to note that there may be limitations or restrictions that apply to certain types of property or businesses. As such, it’s important to work with a tax professional to understand the specific rules and implications of bonus depreciation with rental properties.
Cost Segregation Calculator
A cost segregation calculator for bonus depreciation is a tool that helps businesses calculate the accelerated depreciation deduction they can take on eligible assets.
Here is a practical example of what a cost segregation calculator may look like:
Let’s say that you’re a real estate investor who has just purchased a new commercial property for $500,000. You want to take advantage of the bonus depreciation tax deduction to reduce your tax bill. The IRS allows you to take a 100% bonus depreciation deduction on qualified property that you placed in service after September 27, 2017, and before January 1, 2023.
To calculate your bonus depreciation deduction, you would use a cost segregation calculator. Here’s how it works:
- Enter the cost of the commercial property: $500,000
- Select the tax year: 2022
- Select the type of property
- Select the depreciation method: MACRS (Modified Accelerated Cost Recovery System)
- Click “Calculate”
The cost segregation calculator would then show you the bonus depreciation deduction you can claim on your tax return. In this example, you would be able to claim a 100% bonus depreciation deduction of assets labeled as “land improvements” and “personal property”.
It’s important to note that the bonus depreciation deduction can only be claimed in the year that the property is placed in service, so it’s crucial to take advantage of this deduction before it expires.
Best Cost Segregation Companies
If you would like to take advantage of bonus depreciation for a rental property, you will want to hire a reputable cost segregation company. The best cost segregation company is Madison Specs. They are cost segregation experts and that is their primary focus. Yonah Weiss is a Business Director for Madison Specs and a thought leader for the company helping thousands of real estate investors take advantage of tax benefits on rental properties.
In addition to being a cost segregation study expert, Yonah Weiss hosts a podcast, “Weiss Advice”, where he interviews real estate experts who share their stories. “I’m very blessed to have an amazing network. They say your network is your net worth, and it’s true.” – Yonah Weiss
There are certainly other cost segregation companies and tax professionals out there. Many CPA’s are familiar with accelerated deprecation and can help you with a cost seg study as well. However, if you are looking for the best cost segregation company, we recommend Madison Specs.
Final Thoughts
Cost segregation and bonus depreciation can provide significant tax benefits to businesses and commercial property owners. By properly identifying and classifying assets, it’s possible to accelerate depreciation deductions, reduce tax liabilities, and improve cash flow.
However, it is important to consider working with qualified professionals and follow IRS guidelines to ensure compliance and avoid any potential penalties or audits.
With the right strategy and implementation, getting a cost segregation study for accelerated depreciation can be a powerful tool for maximizing tax savings and optimizing financial performance.
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