Cost segregation is an important tax strategy for rental property owners. But it can be complex. So we will try to make it easy in the cost segregation for dummies post.
When you purchase a building that is a commercial property annual tax obligation is based on several factors such as operating expenses, mortgage interest and depreciation. Purpose of a cost segregation study is to increase and front load deductible depreciation expense. This is accomplished by analyzing the property to find depreciable assets that can be deducted at an accelerated pace.
The shorter the tax life of an asset quicker one is able to gain the benefits of deducting costs of the asset. By hiring an engineer in tandem with an accountant or CPA were familiar with the Internal Revenue Service tax code it is possible to increase your depreciation expense significantly
The deduction for depreciation of MACRS property is determined by using the applicable:
- Method of depreciation,
- Recovery period, and
- Convention.
It can get a little complicated. There are three specified depreciation methods, eight specific recovery periods, and an additional three specified conventions.
Each applies to an asset depending on the class into which the property falls.
- Equipment is depreciated over five years using the 200% declining balance method with a switch to straight-line method in the first year that the use of such method results in a larger deduction.
- Land improvements are depreciated over fifteen years using the 150% declining balance method with a switch to the straight-line method in the year that the method results in a larger deduction.
- Non-residential real property associated with these facilities are depreciated over thirty-nine years using the straight-line method. MACRS provides specific conventions for determining the time period in which depreciation can be claimed when a property is placed in service.
As a general rule, the half-year convention applies to all property except residential rental property and nonresidential real property, which are depreciated using the mid-month convention. The mid-quarter convention must be used, however, for all personal property if the aggregate basis of property that is placed in service during the last three months of the year is more than 40% of the personal property placed in service during the entire year.
The property classifications are as follows:
Personal Property in a Cost Segregation Study
Typical personal property in a cost segregation study includes flooring and carpet, moldings, cabinets, furniture, accent lighting, window treatments, shutters, communication or data lines, and ceiling fans. Personal property can be depreciated over a period of five to seven years. Five-year depreciable property includes appliances, carpeting and furniture used in rental real estate. Track the assets using a template. Seven-year depreciable property includes office furniture and equipment typically required in a commercial property purchase.
The 2017 Tax Cuts and Jobs Act allows 100% depreciation of personal property if the property is purchased between September 27, 2017 and December 31, 2022. This means that the tax benefits for properties purchased during that time will be much greater; instead of depreciating between five and seven years, they can be fully depreciated during the first year.
Let’s consider an example of a rental real estate property that was purchased by ABC Corporation for $10 million dollars. A qualified cost segregation study is performed on the property, with the following amounts attributed to personal property:
Cost Segregation for Dummies
Prior to enacting the 2017 Tax Cuts and Jobs Act, the personal property for this residential building would be depreciated over five years at $200,000 per year. But now things have changed. The personal property can be depreciated at 100% in the first year – resulting in a $1,000,000 tax deduction.
So let’s take a closer look. Let’s assume that a rental has net income of $40,000 for the year. If the entity chooses to depreciate the personal property over five years and chooses to not elect bonus depreciation, the taxable income will be calculated as follows:
- $40,000 less $10,000 personal property depreciation = $30,000 of taxable income
- $30,000 of taxable income x 30% income tax = $9,000 of tax
Net Operating Losses
For IRS purposes, taxpayers that are deemed to be “real estate professionals” can create losses to offset other types of income through the use of a cost segregation study. If a net operating loss is created, the loss can be carried back to prior years.
Cost Segregation for Dummies: Section 179 & Bonus Depreciation
Newly constructed assets with lives of less than twenty years, placed into service within an allowable time frame, will qualify for bonus depreciation. A cost segregation study may create significant bonus deductions.
The decision of whether or not to initiate a segregation cost study solely rests with the purchaser of the property. Cost segregations are affordable for even smaller residential real properties.
For properties exceeding $1 million dollars, it is certainly worth considering. The cost of a study averages $10,000, but varies depending upon the size and complexity of the property itself. Studies are normally able to allocate approximately 15-40% of a building’s value to either personal property or land improvement categories. Such allocation can result in a significant tax savings to the property investor.
Cost segregation has been around for decades. But thanks to tax reform, cost segregation reports can be a huge windfall for real estate owners.
Cost segregation essentially breaks your residential real property into its components, many of which can be depreciated much faster than the typical 27.5 years.
When real estate is purchased, it is typically broken down into two assets for depreciation purposes:
- land, which itself is not subject to depreciation; and
- building.
But a cost segregation study breaks the property down into much greater detail. Here’s what that same property may look like:
- land, which is non-depreciable
- 5-year property
- 7-year property
- 15-year property
- for the remainder, 27.5-year property
With a cost segregation study, you are basically accelerating your depreciation deductions.
Why Accelerating Depreciation Can be Such a Huge Win
The key to this is what is called time value of money – the basic principle that a dollar earned today can be invested using today’s dollars and will be able to compound over time.
Cost segregation can create big tax savings for investors as long as they are not limited by passive loss rules (more about this later).
As an added bonus, tax reform under the recently enacted Tax Cuts and Jobs Act increased bonus depreciation to 100 percent (from 50 percent) and was expanded to include bonus depreciation even on certain used property.
Cost Segregation for Dummies: Rental Losses
When you accelerate depreciation deductions, you will decrease your taxable income or increase your tax loss. If you are a real estate professional, you will most likely not have a problem.
But if these properties are subject to passive loss rules, you may limit your ability to take any real estate losses. But there are a couple options:
- You may have passive income from other rental properties or even capital gains from the sale of passive activities. This will allow you take the losses to the extent of the income.
- You actively participate in your rental activities. You would then be allowed to use up to $25,000 of your rental losses as long as your adjusted gross income is below $150,000 (phase-outs begin at $100,000).
- You or your spouse qualifies as a real estate professional. This is a tax distinction under the law. In addition, you or your spouse must materially participate in the rental activity so that you are allowed to immediately deduct the losses.
Disposition of Residential Rental Property Components
Cost segregation studies also give you an advantage when you repair or improve your property. The study will break out the various components. Using the repair regulations, when a component (such as a roof) is replaced, you have the ability to assign a value to the “old” component and write off its remaining basis.
Let’s take a look at an example. You have a study completed on an existing single family home. The study has a $15,000 value on the roof that was 22 years old when acquired. The roof is being depreciated over 27.5 years (straight-line).
Result. A decade or so later you decide to replace the roof. Thanks to the segregation study, you now know that the remaining basis of the roof is $10,000. Since you have replaced the roof, you can now immediately write-off the existing roof. Not too bad.
Residential Rental Property Strategy
Let’s assume that you have a large increase in income this year and you are looking for a big tax deduction.
If you have residential rental property in service, you have the option to do a cost segregation report and a change in accounting based on the results. You file for the change in accounting on Form 3115.
The result is that you can get a one-time depreciation deduction. It is called a Section 481(a) adjustment and you take it in the year the method is changed. This process essentially “corrects” the depreciation that was missed in prior years.
Cost Segregation for Dummies: Estate Issues?
Unfortunately, death works very well for depreciation and lowering your tax liability.
When a rental real property owner passes away, the real estate gets what is called a step-up in basis on the property. It is adjusted to the fair market value on the date of the owner’s death. This process essentially restarts the depreciation and eliminates any recapture of the prior depreciation taken.
Another benefit is that if you live in a community property state, property that is owned by two spouses under community property laws is allowed a full step-up in basis when only one of the spouse dies.
With the new basis step-up, the beneficiaries now can get another cost segregation report to accelerate the depreciation deductions again. This process can be done over and over even with DIY cost segregation.
Let’s take a look at another example. Nancy and Phil live in a community property state. They acquire a single family rental in 2018 and do a cost segregation study. The study generated bonus depreciation of $20,000 for 2018.
The in 2019, Nancy passes away. The cost basis in the property adjusts to the fair market value on the date of her death. Let’s assume the value of the home did not change. Phil then can take another $20,000 of bonus depreciation for tax year 2019. There is also no recapture for the $20,000 that was deducted in 2018. It is truly and win-win.
Cost Segregation for Dummies: Any Downside?
The cost of the studies was one big downside. But we have solved this with our reports. Many cost segregation reports can cost thousands of dollars.
There can be considerations with 1031 exchanges. Tax reform essentially eliminated 1031 exchanges for non-real property. As a result, if you do a 1031 exchange, you can have a taxable gain relating to assets that are not assigned a 27.5-year life.
There also can be an issue with ordinary gain on the sale of property. When the real estate is sold, any 5-year or 7-year components will typically be Section 1245 property. The depreciation recapture on these assets can result in ordinary gain that is taxed at marginal tax rates.
Let’s look at the numbers
So let’s assume you acquire and place in service a new residential rental property in 2018. The home was purchased for $220,000 and, after excluding land, it has a remaining basis of $180,000.
Based on an example of cost segregation for residential real property, the following items were determined for depreciation purposes:
· 5-year property: $20,000
· 15-year property: $20,000
· 27.5-year property: $140,000
The result is that $40,000 can be written off immediately thanks to bonus depreciation. Let’s assume that you are in a combined 35% tax bracket and you will save $14,000 in taxes.
Cost Segregation for Dummies: Summary
So if you are considering if cost segregation is worth it, you have a lot of issues to consider. A cost segregation study that is able to accelerate depreciation and lower your tax liability is always a good strategy. Just make sure that you are not limited in deducting the depreciation as a result of the passive activity rules.
Also, make sure that the cost of the study itself is reasonable and provides you with a favorable return on your investment. Don’t forget the fact that you may have ordinary income depreciation recapture when you sell the property as a result of the segregation study.
In addition, make sure that you communicate with your accountant and review the cost segregation report in detail. As long as you plan correctly, cost segregation studies can provide tremendous benefits.