Cost segregation is a little understood but extremely valuable tool that all real estate investors should know about. Essentially, it’s a way to frontload depreciation and get the tax benefits all at once.
Bonnie Griffin Kaake of Cost Segregation Services, Inc joined me to explain what cost segregation is and some of its important nuances.
- Listen to the podcast “#104: How the Rich Minimize Taxes: Building Wealth with Cost Segregation” on the Colorado Springs Real Estate Investing Podcast
- Watch the YouTube video (at the bottom.)
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
What Is Depreciation, and How Does It Relate to Cost Segregation?
Depreciation is the process used to deduct the costs associated with the reduced useful life of the improvements (structure) of a rental property. It’s one of the four ways you earn a return in real estate.
The IRS requires owners to take depreciation on their taxes every year. It’s measured over 27.5 years for residential properties and 39 years for commercial properties. Depreciation is typically calculated by looking at the structure because the land itself doesn’t depreciate. Each year, owners can more or less take 1/27 or 1/39 of the depreciation out of their taxes.
With cost segregation, you can get the bulk of the depreciation upfront, usually 25%-30% of what you paid for the property, depending on what the cost engineer finds in your property.
A cost segregation study looks at the building and figures out how to separate out various components within the structure that can depreciate on an accelerated schedule than the overall schedule of the building itself (e.g. appliances, flooring, etc.)
In certain tax years as defined by the Tax Cuts and Jobs Act, the investor can depreciate the entire amount of the identified accelerated schedule components due to bonus depreciation, and can be taken in the first year. This results in a significant front loading of depreciation.
An example of the outcome of a cost segregation illustrates the potential savings. A property without the land is valued at $500K. A cost segregation study determines that 30% of the value can be depreciated upfront, giving you $150K. If your tax rate is 30%, that means you’re saving $45K in taxes this year. If you were to take normal depreciation, you would only save $18K.
Bonnie recommends using a reputable company like Cost Segregation Services to perform the study so that you don’t trigger an IRS audit.
What Are Some Nuances to Depreciation Investors Should Know About?
There are many nuances to cost depreciation that can be easy to miss:
- As defined by the IRS, Real Estate Professionals, in most cases, can use the depreciation from a property against a W2 or Sch C, non-passive income.
- If a business owner also owns the building they operate out of, they can group the business and the building to use the depreciation against their income.
- Short term rentals should be depreciated over 39 years because they’re a business. The use of the structure is what determines the depreciation schedule, not the building type.
- Older owners who plan to pass their house onto their heirs should do a cost segregation study. That way, they will get the money now. When they die, their heirs will receive the house at its current market value (stepped-up basis), allowing them to do their own cost segregation study.
If I Frontload Depreciation Now, Am I Hurting Myself Later?
Many investors worry that if they deduct a larger depreciation amount now, it will hurt them in the future. However, most investors will find that the overall difference is only a few thousand dollars in subsequent years.
It’s important to keep in mind that getting the money upfront allows you to invest more now, which will generate its own returns over the long run.
How Can I Learn More about Cost Segregation?
If you want to learn more about how cost segregation can help you, connect with Bonnie:
- Email: [email protected]
- Cellphone: 303-475-4459
- Office: 720-504-5776
Need help figuring out your overall investment strategy? Reach out to me for a free investment consultation.