Cost segregation is a highly effective and powerful tax-saving strategy that enables real estate investors to accelerate their depreciation deductions to increase their immediate cash flow. Instead of viewing a property as a single asset, a cost segregation breaks the property down into various high-value components that can then be depreciated on shorter schedules.
As a beginner in the world of real estate, sometimes it can feel like you’re learning a new language. There’s so much to digest between cap rates, cash-on-cash returns and escrow that it can become a little overwhelming. However, if there was ever one thing that every first-time real estate investor needs to become well-acquainted with, it’s rental property depreciation.
Although most investors understand the basic concepts regarding writing a building off over several decades, the more astute investors know that a cost segregation is a secret weapon to unlocking significant amounts of liquidity in their real estate assets.
For investors wondering if a cost segregation study would be worthwhile, a real estate depreciation calculator is a strategic tool that will enable you to estimate the potential savings you could get from cost segregation. This will aid in determining if getting a study is worth it for your property. If you’re looking for a guide on cost segregation for beginners, this article will outline how you can turn your paper losses into real-world profits.
What is Cost Segregation?
Cost segregation is essentially an advanced real estate tax strategy that involves segregating or reclassifying specific components of your property into shorter depreciation cycles. The IRS requires you to depreciate a residential property over a span of 27.5 years and a commercial property over 39 years. This applies to the building specifically, and not the land.
Under these regulations, you would basically have to wait 27.5 years just to recover the cost of a new carpet or fence, but thanks to cost segregation, that’s no longer the case. After performing a cost segregation study on your property, you would be able to depreciate those assets over significantly shorter schedules of 5, 7 or 15 years.
When you front-load these deductions, you significantly reduce your taxable income over the first few years of ownership, allowing you to keep more capital that you can then reinvest into your portfolio.
How Properties Are Divided into Asset Classes
In the process of conducting a cost segregation study on your property, an engineer will view your physical asset as a collection of high-value components as opposed to just a single building. They will then divide these assets into different classes with varying depreciation schedules.
Personal Property
Your personal assets typically fall under the 5-7 year recovery schedule and generally pertain to items that are not structural. This includes things like:
- Appliances
- Carpeting
- Decorative lighting
- Cabinets
- Window treatments
Land Improvements
Land improvements normally get reclassified under the 15-year depreciation schedule and comprise items that are outdoors but still within the bounds of the property.
This can refer to:
- Paved parking lots
- Fences
- Sidewalks
- Landscaping
The land itself never wears out according to the IRS’s regulations, and therefore cannot be depreciated. Isolating the first 2 categories can often reclassify between 20-40% of the property’s asset price into accelerated schedules.
Bonus Depreciation
For first-time investors, bonus depreciation is the most exciting part of this strategy. Under the Tax Cuts and Jobs Act, investors can often take 100% of the depreciation for 5-, 7-, and 15-year assets in the very first year they own the property.
Although the bonus depreciation percentage is gradually phasing down, this is still one of the most widely implemented tools in rental property depreciation.
Why Cost Segregation is Invaluable To Any Property
Many investors find themselves questioning the value of cost segregation for smaller properties; however, this strategy can be highly effective even if you don’t own a multi-million dollar apartment complex.
Return On Investment (ROI)
Small property cost segregation has become an incredibly popular choice for owners of single-family rentals and Airbnbs. Now that the cost of a professional study has dropped significantly, even a $300,000 property can see a massive Return On Investment (ROI). If a study costs you $2,000 but saves you $15,000, then the value of the investment is clearly a no-brainer.
Achieving REPS Status
Cost segregation also doesn’t only apply to your rental income, because it can also be used to offset your W-2 or active income as well. However, qualifying as a real estate professional is necessary to enjoy these benefits.
To qualify as a real estate professional, you must meet two primary time-related criteria:
- 750-Hour Rule, which stipulates that you must spend more than 750 hours in real estate trades or businesses in which you materially participate.
- More than half of the personal services you perform in all trades or businesses during the year must be in real estate activities.
Big Returns For Beginner Investors
Cost segregation is a powerful tool for any budding real estate investor because it gives you some much needed liquidity when you’re just starting. In a market where every return matters, this significant advantage will certainly go a long way in helping you scale your portfolio.
