One of the top tax benefits available to real estate investors is depreciation, the income tax deduction that comes from spreading out the cost of a property over the time that you use it and deducting a portion of its cost each year. Cost segregation, in turn, is a tax strategy that can be used to accelerate depreciation deductions — so it’s definitely worth knowing about.
Keep reading for a look at how cost segregation in real estate works and if this often-overlooked planning tool might make sense for you.
Key Points
• Cost segregation allows property owners to categorize components of their investment property into shorter depreciation periods, potentially enhancing tax savings.
• Conducting a cost segregation study identifies property components that may be eligible for reclassification.
• Properties with numerous reclassifiable components, like commercial real estate, often benefit significantly from cost segregation.
• Compliance with IRS guidelines is essential, and detailed documentation is necessary.
• It’s best to work with a tax professional who has experience with cost segregation to ensure accurate asset reclassification and maximize tax savings.
Definition of Cost Segregation
Cost segregation is a tax planning tool used by businesses and those who invest in real estate to accelerate depreciation deductions on certain parts of their properties.
Basic Concept
Instead of using just one or two categories (or asset classes) to calculate the depreciation on a property for income tax purposes, cost segregation separates the property into multiple categories, some of which have shorter depreciation periods. This allows property owners to claim a larger portion of their depreciation deduction sooner, which can lower their tax liability and increase their cash flow. (Remember to consider the full list of possible tax strategies as an investment property owner, including offsetting rental income with deductions such as the mortgage interest deduction.)
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Purpose in Real Estate Investing
For real estate investors, depreciation is typically divided into two categories: building and land. Land doesn’t depreciate for tax purposes, but buildings do. Generally, residential buildings are depreciated over a 27 1⁄2-year period, according to IRS requirements, and nonresidential buildings are depreciated over a 39-year period.
Because the depreciation period on a building is so long, the yearly deduction owners get doesn’t necessarily amount to significant savings. Though the depreciation deduction adds up over time, it can take a while for an owner to realize the tax benefit. Some owners paying for a property with a home mortgage loan may think about exploring cost segregation to capture tax benefits to counteract those monthly payments. (They may also want to read up on how to avoid capital gains taxes on real estate.)
Cost segregation analysis puts additional categories beyond land and building into the mix, which means some parts of the property (certain fixtures, site improvements, or equipment, for example) may be depreciated over a shorter period of time (typically five, seven, or 15 years). This can give owners the ability to take larger deductions sooner, which can result in substantial tax savings, potentially accelerating the return on investment and boosting the overall financial performance of the investment.
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How Cost Segregation Works
Cost segregation analysis requires identifying and reclassifying building components into categories that have shorter depreciation periods for tax purposes. This can allow real estate investors to accelerate the depreciation deductions for these specific items and lower their tax liability earlier in their ownership of the property.
For example, plumbing fixtures, furniture, equipment, and other components that aren’t permanently attached to the building could potentially be classified as personal property and depreciated over five years instead of 27½ or 39 years. Site improvements (such as landscaping, paving, and fencing) could be classified as land improvements and depreciated over 15 years. These tighter timelines can allow an owner to take advantage of available tax breaks sooner rather than later.
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Cost Segregation Study Process
Usually, the first step in deciding if and how to use cost segregation is to hire a financial firm (preferably one with expertise in engineering and tax law) to perform a cost segregation study on your building and its systems. What is a cost segregation study? Your team will:
• Analyze your property to determine which components can be separated into categories with shorter depreciation periods.
• Use documentation — such as home inspection reports, a recent property appraisal that shows how much the house is worth, closing documents from the property sale, and other relevant records — to inform and support their decision-making.
• Prepare a report that shows you how much you might save on taxes by implementing a cost segregation strategy.
You can then use this information for tax planning and preparation purposes.
Benefits of a Cost Segregation Study
The goal of cost segregation is to reduce your tax liability so you can put that money back into your business, perhaps with improvements or by taking out another investment property mortgage. But a cost segregation study may offer other advantages, as well. Here’s a breakdown of the benefits a professional cost segregation analysis may provide:
• Increasing tax savings by reducing the depreciation period for certain assets.
• Increasing cash flow and improving the overall return on investment by accelerating depreciation deductions.
• Improving asset management and offering a more accurate accounting of the property’s assets and their value.
• Finding other potential tax credits and incentives.
• Ensuring compliance with tax laws and IRS regulations.
Types of Properties Suitable for Cost Segregation
Cost segregation could be a useful strategy for a wide range of real estate investments. But it can be especially well-suited to properties that have specialized equipment, systems, or a significant number of other assets that could be reclassified to a shorter depreciation period, such as:
• Commercial real estate like retail spaces, office buildings, and warehouses
• Rental properties, including multifamily residential buildings
• Resorts and restaurants
• Medical facilities
When Should You Consider Cost Segregation?
Timing can be an important factor when considering a cost segregation strategy. You can order a study at any time, but it may be particularly useful if you’re the owner of a newly constructed building, a recently remodeled or renovated property, or a newly acquired property. This way you can use the information when you file your tax return and maximize the tax savings at a time when you need it most.
Cost Segregation Methods
There aren’t any established requirements for the preparation of cost segregation studies, but according to the IRS, six of the most common approaches include:
• Detailed Engineering Approach from Actual Cost Records: Uses actual records — blueprints, specifications, contracts, job reports, and other construction documents — to determine costs.
• Detailed Engineering Cost Estimate Approach: This is similar to the approach above, but it uses estimated instead of actual costs.
• Survey or Letter Approach: Contractors and subcontractors are contacted to provide information on the cost of specific assets that they installed on a particular project.
• Residual Estimation Approach: This is a shortened method for which only short-lived asset costs are determined. The total amount of these asset costs are subtracted from the total project cost.
• Sampling or Modeling Approach: This method uses a model (or template) to analyze multiple facilities that are nearly identical in construction, appearance, and use.
• Rule of Thumb Approach: This approach generally uses little or no documentation and is based instead on the preparer’s “experience” in a particular industry.
Working with Cost Segregation Professionals
You may find it helpful to use an online calculator to help you estimate how much you’ll save on taxes and to decide if it’s worth proceeding with a cost segregation strategy. But when it’s time to do the actual study, it’s generally not a DIY job. (According to the IRS’s Cost Segregation Audit Technique Guide, the No. 1 element of a quality study is “Preparation by An Individual with Expertise and Experience.”)
Engineering firms, tax advisory firms, construction cost consultants, and some large accounting firms often have a team of specialists that perform this type of work. Or you may be able to find a cost segregation firm that focuses exclusively on providing cost segregation studies.
Costs Associated with Cost Segregation
The price of a cost segregation study may vary significantly depending on several factors. But you can expect to pay anywhere from $5,000 to $30,000 or more based on the size of the property, the assets being analyzed, location of the property, the level of detail in the study, whether the work is done in person or remotely, and the experience and reputation of the firm doing the work. It can be helpful to do some comparison shopping and to get quotes from the firms you think could be the best fit for your goals.
Once you’ve estimated the costs involved, you can decide if the tax and other potential savings are worth the time, effort, and money that will go into a cost segregation study.
IRS Guidelines and Regulations
According to the Cost Segregation Audit Technique Guide, to meet IRS expectations, a taxpayer should submit a “quality cost segregation report” supported by a “quality cost segregation study.” The guide provides an in-depth look at what it takes to meet those expectations and the legal and legislative precedents that got us where we are today. And it stresses that taxpayers must be able to substantiate their asset classifications and depreciation deductions.
The Takeaway
Cost segregation is a complex tax deferral strategy that allows real estate investors to lower their tax bills earlier in their ownership by reclassifying certain parts of their property to shorter depreciation periods. This can help them free up money sooner for reinvestment or other purposes.
You may want to talk to a financial professional about whether cost segregation would benefit you, and how to find the right team to get the process started.
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FAQ
How much can I save with cost segregation?
Several factors can go into determining how much you could save with cost segregation, including the cost of your property, whether you have assets that can be reclassified to a shorter depreciation period, and how much your cost depreciation study costs.
Is cost segregation only for new properties?
A cost segregation may be more efficiently executed for a new property or one that’s been recently renovated. But by using a “look-back” study, the strategy could also be used on a property that you’ve owned for several years.
How long does a cost segregation study take?
It could take the firm you hire one to two months to complete your cost segregation study, depending on the size of your property and how helpful you can be with providing the information and documentation they require.
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