Cost segregation studies are implemented by real estate investors all the time. But few investors really know what goes into a report. In this post, we look at a cost segregation report example.
They will generate tax savings by identifying personal property and land improvements relating to a purchase. These assets will then be assigned shorter useful lives that will generate accelerated depreciation expense.
These personal property assets and land improvements are classified with a 5, 7 or 15-year life. While rare, we have seen situations in which as much as 40% of a building’s components are reclassified into one of these accelerated depreciation classes.
At the conclusion of the report, a depreciation schedule is generated that can be provided to a CPA as supporting documentation for the tax return filing. It also serves as support in case of an IRS audit.
In this post, I will examine three detailed examples of cost segregation report depreciation schedules for residential rentals. That way you can see the report conclusions yourself.
Cost Segregation Report Components
The average report length is approximately 20 pages. You will see citations of court cases supporting the results. These will typically be outlined along with the 13 elements.
An important part of the report will be the discussion regarding the methodology. There are different methodologies that can be used. Some are more accurate and reliable than others.
But the key part is identifying and allocating costs for the personal property. The IRS has defined many elements (thirteen to be exact) of a quality cost segregation report:
- Preparation by a person with expertise and adequate experience
- A detailed and specific description of the methodology utilized
- Appropriate level of documentation
- Interviews as required with any appropriate parties
- Use of a common terminology and nomenclature
- Use of a defined numbering system
- Thorough explanation of the legal aspects and analysis
- Specification of unit costs and a detail of engineering “take-offs”
- Organization of related assets into depreciation groups (or lists)
- Reconciliation of the property costs between asset groups and actual costs
- Explanation of the related treatment of any indirect costs
- Identification and listing of personal property (§ 1245 property) and land improvements
- Consideration of any related aspects (i.e. property uniqueness, sampling strategies, examples, changes in accounting methodology, etc)
Cost Segregation Report Example: Personal Property
- Appliances, including stoves and refrigerators
- Furniture or equipment
- Carpeting or vinyl flooring
- Ceiling fans
- Molding and decorative items
- Wall coverings
- Accent lights
- Window treatments, including blinds and shutters
- Security and water treatment systems
- Exterior lighting
- Pool equipment
- Specialty plumbing and electrical
So let’s jump into the report examples. All of these sample reports have some differences in cost basis, property components and amenities. I have assumed for this post that all the properties were placed into service on January 1st. That will allow for a full year of depreciation for illustration purposes.
Cost Segregation Sample Report: Single Family Home in Arizona
The first report example is a rural adobe home in Arizona. The investor acquired the house for $285,000. The goal is to rent the home for 5-7 years and then sell with a 15% internal rate of return. Whether the investor can meet the required rate of return will be seen. But a cost segregation report was desired to offset current taxable income.
So a few things I wanted to discuss:
- At first glance you will notice that the 5 year and 15 year property can be fully depreciated in year one. As previously discussed, this is a big thanks to tax reform changes. The opportunity to immediately depreciate 5, 7 and 15 year property has been a pleasant surprise for many real estate investors.
- There is no breakout for flooring. This is because the entire home is tile flooring. Tile is structural in nature and is depreciated over the building life (27.5 years). If the property had carpet or vinyl flooring that would have been separated out.
- You will see that the study produced year one tax depreciation of over $49,000. This amount is over 17% of the cost basis of the property. Not such a bad deal.
Cost Segregation Report Example: Florida Home
This next report example is a home in Florida. It is a 2,600 square foot rental that was purchased for $418,000. The home is a little older and could use some upgrading. The owner is from New York, but has been acquiring rentals in Florida for several years.
A couple things to note in this report:
- There is an allocation for a pool. Many people do not realize that a swimming pool can be depreciated. Above ground pools are not structural to the property and in ground pools are land improvements. Many landlords don’t buy homes with swimming pools because of the legal exposure. But they still can make nice investments if purchased right and if you can get a rent premium.
- The backyard has significant fencing, concrete, paving and other land improvements. These are allocated a 15 year life, but do qualify for 100% bonus depreciation under tax reform.
- There is a relatively high land allocation. The property is close to the water and lots in this area have tended to get a little pricey. This can be common for homes in coastal areas. The land allocation in these areas will tend to be higher than in other parts of the country, like the Mid-West.
Cost Segregation Sample: Washington
This last report example is for a fixer upper in Washington. A seasoned investor purchased the home for $388,000. It needs a little TLC, which becomes evident when you take a look at the asset allocation.
A few thoughts about the example report:
- There is no allocation for kitchen cabinets. It appears that the cabinets were in such bad shape that there was literally no value. That’s unusual because kitchen cabinets that are not structural and can be dismantled with little damage to the structure are typically one of the highest allocations to personal property that you will find.
- As a result of the cabinets, there is a high allocation to building structure (27.5 year life). This is often the case with fixer uppers. The personal property is often damaged and of little value, which can mitigate the tax advantages to a cost segregation report. But on a positive note, if you can allocate value up front then you can write off the personal property once it has been replaced.
- The report produced depreciation in year one of over $39,000. This amount is over 10% of the cost basis of the property. A little on the low side.
As we can see from the cost segregation report example, the results can be different for different properties. Cost segregation studies can be great tax strategies for real estate investors. When you combine bonus depreciation on personal property, it becomes a game changer.
Investors should due their diligence and consult with an experienced real estate CPA to make sure that they are able to take advantage of the immediate tax savings. Make sure that you employ an experienced cost segregation firm so you can maximize your tax savings and minimize any IRS issues.