According to a recent study released by the National Association of Realtors, approximately 23% of homes purchased fell into the category of investment property or residential rentals. With the surge of new buyers entering the field of property investment, many are unaware of how real estate depreciation actually works.
Cost segregation studies are commonplace to experienced real estate investors. They accelerate the tax benefits by identifying, classifying and segregating building components into short-term depreciation categories.
A cost segregation study for single family homes can produce a summarized report on the personal property (sometimes called chattels or components) of the home. This is generally the appliances, floor coverings, window treatments, water heaters, landscaping, etc.
The study will generate a depreciation schedule that can then be provided to a CPA or tax professional as supporting documentation for preparing the tax return. They also serve as support for an IRS audit.
These assets are reclassified as personal property with a 5, 7 or 15-year lifespan. In some cases, up to 40% of a building’s components can be reclassified into an accelerated depreciation class.
But is a cost segregation report for single family homes cost effective?
One big problem exists. Traditional cost segregation studies are expensive. A typical report can run thousands of dollars and we often see report costs that exceed $10,000.
But does that make much sense for single family homes costing $200,000? Of course not. There is a simpler and more cost effective approach.
At Simple SEG, we only do cost segregation studies for single family homes under $500,000. This type of property is what we know and we can complete a study for just $299.
In this post, we wanted to take a look at three specific examples of cost segregation studies for single family homes. That way you can see the results for yourself.
Tax Reform and Residential Rentals
But before we dive into the examples, we wanted to take a look at some recent tax reform changes. The Tax Cuts and Jobs Act of 2017 (TCJA) introduced some important changes to the federal tax code including lowering tax rates for corporations, certain pass-through entities, and individuals.
Bonus depreciation and significant tax savings opportunities through cost segregation is an important area that every investor should look into.
A cost segregation study allows real estate asset owners to identify parts of their property that can be treated as personal property for federal tax purposes. An owner can, therefore, know the part of the property to depreciate under a 39-year period, or much shorter ones like five, seven or 15-year personal property. The accelerated depreciation deduction relieves the property owner of the tax burden by writing off parts of properties with the high tax base.
Before the TCJA, only 50% bonus depreciation was allowed for qualifying assets, 40% in 2018. Bonus depreciation increased to 100% for assets new and used properties acquired after September 27, 2017.
The bonus depreciation provision was initially meant to stimulate growth and encourage an investment back to the economy. It originally provided for 30% bonus depreciation in the first year of use of an asset which was new and had a 20 year or less tax recovery period.
Cost segregation is therefore important especially to a used property acquired after September 27, 2017. For instance, a taxpayer who acquires a warehouse in 2018 for $1.5 million conducts a cost segregation analysis. He finds out that about $200,000 relates to 15-year land improvements and another $100,000 related to a five-year personal property.
The TCJA, therefore, allows the owner bonus depreciation on the property. The owner can deduct $300,000 which translates to $90,000 tax saving using a 30% tax rate.
So now that you have some background, let’s jump into the examples. All of these examples have some differences. This includes location (Nebraska, California, and Nevada) and amenities. I also assumed the properties were all placed into service on January 1st, so that a full year of depreciation is applicable.
Example #1: Single Family Home in Nebraska
The first example is a ranch style home in Nebraska. The investor purchased the property as a long-term rental for $174,159. The investor has a large portfolio of properties and looks for cost segregation studies to accelerate depreciation that can be used to offset gains from property sales.
A couple things I want to point out:
- First, you will notice that all of the 5 year property and 15 year property is fully deducted in the current year. As noted above, this is thanks to tax reform. The ability to write-off 5, 7 and 15 year property immediately has really been a game changer.
- The land value is only 10%. I have seen CPAs use a 20% or 25% land value as a “rule of thumb.” The reality is that the land value could be as low as 10% (or even lower) and as high as 75% (pretty rare). In this case, land prices in this area of Nebraska are relatively low. Based on surrounding comparable sales, this low land valuation was reasonable. But this isn’t always the case (take a look at our next example).
- The property had extensive carpeting which resulted in higher valuations in the flooring bucket.
- You can see that the cost segregation study produced first year depreciation deductions of over $55,000. This is over 31% of the purchase price. Not too bad.
Example #2: Cost Segregation Study on Single Family Rental in California
This next property was another rental purchased for $495,660 in Southern California. It was just below our maximum value of $500,000.
Now $500,000 does not get you as much home in California as it does in Nebraska. In this case, it only gets you 1,300 square feet. But California has the highest state income tax rates in the country, so a cost segregation report comes in very handy.
A couple things to note:
- The land value is substantially higher than the previous example. Land prices are high in California hence the land valuation in excess of 23%. Of course, land is not subject to depreciation so the high valuation is not beneficial in the study.
- The flooring valuation was lower in this example even though the cost of the property is so much higher than example #1. This is the case because the square footage is lower, but also primary because a substantial portion of the home was tile flooring which is not eligible for a personal tangible property allocation.
- Fencing and decking received a higher allocation. Many rural areas have minimal fencing, but urban environments often have block or stucco walls.
Example #3: Cost Segregation Study on Single Family Home in Nevada
The last of the residential rentals was purchased by a real estate investor in Las Vegas. The purchase price was $265,000 and it was a foreclosure. Let’s take a closer look:
- Foreclosures can present valuation issues. In this case, the property had no appliances, carpeting, or blinds. Accordingly, there was no valuation for such amounts. This is often the case for properties purchased at auction.
- The property did, however, have decent cabinets and counter tops. The property received a reasonable allocation for such amounts based on the type and condition.
- The final allocation was only a $42,000 allocation to 5 year and 15 year property. The result was the lowest overall allocation to personal property of only 15%.
As we can see from the examples, cost segregation studies for single family homes and residential rentals can have many different results. It is important to consider the type and age of the property in addition to the personal property.
Cost segregation studies on single family homes are a great tax strategy. When combined with bonus depreciation, it is an important tax saving tool for real estate investors.
Investors should consult with experienced CPAs and tax professionals to properly take advantage of the deduction opportunities and understand how to utilize both section 179 and the tangible property regulations. Make sure that you do an adequate study in order to maximize your tax deductions and keep your distance from the IRS.