Regardless of whether you have heard about using a cost segregation study to accelerate depreciation deductions on an investment property, you undoubtedly are aware of the benefits of depreciation as it relates to creating tax-efficient cash flow from rental property.
The depreciation deduction is the allowable percentage of depreciable value of the property over the specified time frame for that asset class (27.5 years for residential property, 39 years for commercial property). This amount represents the theoretical decrease in the value of the property over the “useful life” of the property. Taking the depreciation deduction for rental property is not optional, at least in the sense that the IRS considers it to be taken whether you actually take it or not. This depreciation deduction is what allows for the situation of positive cash flow on a property over the course of a year yet still ending up with a “paper loss” on your tax return. Say for example the annual income was $60,000 and actual expenses were $24,000 (40%) and annual debt service was $24,000. This would equate to total cash flow of $12,000 over the year, but once the depreciation deduction is taken, let’s say $10,00 in this example, the taxable income is then $2,000. You can see the benefit of being taxed on $2,000 and actually pocketing $12,000 is a pretty good deal.
In that scenario, the depreciation deduction is based on the total building cost as a whole (not land which is not depreciable) spread out over the depreciable lifespan of that asset as determined by the IRS. With a cost segregation study, the component parts of the building (land improvements) are broken down into various categories which allow for them to be depreciated on a shorter timeframe than the typical 27.5 years for residential property (or 39 years for commercial). It makes sense that many of the items within a building have a shorter useful lifespan than the building structure itself, things like carpet, window treatments, cabinets, etc. These kinds of items can be depreciated on an accelerated schedule of 5, 7, or 10 years. It doesn’t mean you get any additional depreciation from them, it just means you get to take the depreciation sooner in the investment than later and therefore lessen the amount of tax liability early on. With less tax liability, you get to keep more of your cash flow early on which if then also invested gives you a financial benefit due to the time value of money.
Although the typical depreciation deduction is fairly easy to calculate based off of building cost and land value, the allowable depreciation as determined by a cost segregation study is not something you can undertake or are even allowed to do on your own even if you wanted to. To complete a cost segregation study requires hiring a specialized engineer that formally completes a study of the components and associated value of all land improvements on the property. That study can then be utilized by your accountant to take the accelerated depreciation over the years in which you hold the property.
So is a cost segregation study right for all property owners? No, there really is a cost-benefit analysis that must be done to see if the time, effort, and expense of doing a cost segregation study makes sense for a particular investment. The cost of hiring an engineer to perform the study could easily be $5,000 - $15,000 depending on the scope of the project, so that cost would have to outweigh the projected tax benefit and time value of money benefit. For some investors, minimizing the tax liability from cash flow (or even creating passive losses from depreciation) is a significant goal and this could be a way to do that. But like most things, it’s best to look at the big picture to see what makes sense for each individual situation.
It is also important to realize that just like the depreciation normally taken on a rental property, any accelerated depreciation taken from a cost segregation study is subject to depreciation recapture taxation upon the sale of a property. For more information on that topic check out this previous blog post: http://physicianrei.com/a-simple-look-at-depreciation-recapture/. With that in mind, it likely wouldn’t make sense to embark on doing cost segregation on a property an investor was planning on selling outright in the relatively near future. However, the depreciation recapture tax can be deferred through a 1031 exchange.
Having sold an investment property before without doing a 1031 exchange, I like to point out that even if you aren’t able to utilize passive (paper) losses every year during the hold period of an investment, those losses do roll forward and can be applied to reduce your taxable basis if/when you sell a property in the future which is another useful strategy. So, like almost every tool and technique in real estate investing, there are pros and cons and benefits and drawbacks but by stepping back to look at the big picture every once in awhile and by learning about some additional “tools” you can make the decisions that best suit the goals you are trying to accomplish within real estate.
Have you done a cost segregation study before? Feel free to chime in with your experience with it and let us know how it benefited you.